Lawless Capitalism: The Subprime Crisis and the Case for an Economic Rule of Law 9780814777299

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Lawless capitalism

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Lawless Capitalism The Subprime Crisis and the Case for an Economic Rule of Law

Steven A. Ramirez

a NEW YORK UNIVERSIT Y PRESS New York and London

NEW YORK UNIVERSITY PRESS New York and London www.nyupress.org © 2013 by New York University All rights reserved References to Internet websites (URLs) were accurate at the time of writing. Neither the author nor New York University Press is responsible for URLs that may have expired or changed since the manuscript was prepared. Library of Congress Cataloging-in-Publication Data Ramirez, Steven A. Lawless capitalism : the subprime crisis and the case for an economic rule of law / Steven A. Ramirez. p. cm. Includes bibliographical references and index. ISBN 978-0-8147-7649-0 (cl : alk. paper) ISBN 978-0-8147-7650-6 (ebook) ISBN 978-0-8147-7729-9 (ebook) 1. Global Financial Crisis, 2008-2009—Moral and ethical aspects. 2. Financial crises— Moral and ethical aspects—United States. 3. Capitalism—Moral and ethical aspects— United States. 4. Corporate governance—Moral and ethical aspects—United States. 5. Business and politics—United States. 6. Financial institutions—Law and legislation— United States. 7. Law and economics. 8. Liability (Law) I. Title. HB37172008 .R36 2012 174—dc23 2012024880 New York University Press books are printed on acid-free paper, and their binding materials are chosen for strength and durability. We strive to use environmentally responsible suppliers and materials to the greatest extent possible in publishing our books. Manufactured in the United States of America 10 9 8 7 6 5 4 3 2 1

To the entire Ramirez Family, who stand as testament to the benefits of broadly distributed economic empowerment

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Contents

Acknowledgments Preface: A Historic Collapse of Capitalism

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Introduction

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1. A Revolution in Economics (but Not in Law)

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2. The Corrupted Corporation

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3. Animal Spirits and Financial Regulation

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4. Rigged Globalization

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5. The Costs of Economic Oppression

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6. The Crisis in Crisis Management

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7. The Potential for an Economic Rule of Law

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Epilogue: Optimized Legal Infrastructure and the End of Scarcity

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Notes Index About the Author

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Acknowledgments

I am greatly indebted to the following individuals for reviewing all or part of this book and improving it: Laura Caldwell, andré cummings, Joe Grant, Chunlin Leonhard, Katrina Ramirez, Mary Ramirez, Barry Sullivan, Alexander Tsesis, and Spencer Waller. The book also benefited from helpful discussions with Timothy Canova, Richard Delgado, Christian Johnson, Tayyub Mahmud, Bud Murdock, John Nowak, Christopher Peterson, Jean Stefancic, and Cheryl Wade. I also received excellent suggestions from a number of anonymous reviewers. Loyola University Chicago generously provided financial support of this project. NYU Press, and Deborah Gershenowitz in particular, provided perfect editorial support at all phases of the project. Professor Regina Burch of Capital University, Professor Linda Crane of the John Marshall School of Law, and Professor Steven Bender of the University of Seattle helped arrange presentations of this book at their respective institutions. Professor Neil Williams arranged for the book to be presented at the Midwestern People of Color Legal Scholarship Conference held at Marquette University in April 2012. The Wayne Morse Center for Law and Politics at the University of Oregon also hosted a presentation of this book. Of course, all errors and omissions remain solely my responsibility.

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Preface: A Historic Collapse of Capitalism It is to be regretted that the rich and powerful too often bend the acts of government to their own ends. President Andrew Jackson (1832)1

On September 13, 2008, CEO Jamie Dimon told his senior management team at JP Morgan Chase: “You are about to experience the most unbelievable week in America ever.”2 Dimon summed up the outcome for the Chase bankers of extended late night meetings with government officials and fellow banking executives: The government would not bail out Lehman Brothers, and he envisioned a systemic failure of many other Wall Street banks, leading to a near-total financial collapse. On September 15, 2008, Lehman Brothers, one of America’s oldest investment banks, declared bankruptcy. On Tuesday, September 16, 2008, the Reserve Primary Fund, the nation’s oldest money market mutual fund, “broke the buck” when its shares fell to 97 cents, after accounting for losses on short-term debt obligations issued by Lehman. This caused a massive and historic run on money markets and short-term debt markets around the world. Holders of such obligations reacted to risks of loss that previously seemed remote—that the government would permit a major financial institution to fail—and this deep risk aversion spread rapidly >>

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from a lack of capital for loans. It further purchased hundreds of billions of dollars in commercial paper to ensure that the business sector would not collapse from a sudden loss of short-term credit. The government guaranteed the value of trillions of dollars in outstanding mortgages through its costly takeover of government-sponsored entities (Fannie Mae and Freddie Mac) that operated at the core of the mortgage financing business.9 Finally, in the spring of 2009, the government passed a $787 billion stimulus bill in an attempt to revive a credit-starved economy.10 These actions constitute only the most high-profile bailouts. At the height of the crisis, President George W. Bush asked Treasury Secretary Paulson, “How did we get here?”11 How did American capitalism find itself in a position where such massive and extraordinary rescue efforts became necessary? In a word: recklessness. The nation’s largest financial institutions gorged on levels of risk—particularly in the subprime (even predatory) mortgage business—unparalleled in U.S. financial history.12 Reckless mortgage lending triggered a global meltdown of capitalism. Very often, mortgage lenders did not even bother, for example, to verify borrower income, instead simply telling borrowers the income they should state on their applications in order to qualify for a given loan. Down payments nearly vanished.13 Amazingly, they even failed to secure the right to foreclose through the execution and recording of valid mortgages.14 Worse yet, they lost original promissory notes—negotiable instruments under law.15 Most recklessly, some banks even destroyed original notes.16 In an era of more computing power than ever, and with hordes of mathematicians modeling risk on Wall Street, the most sophisticated financiers in history botched mortgage lending, a business that seems as old as business. Worse, the financial institutions took this risk on board through very high levels of debt—or leverage—on their own balance sheets, meaning that even small losses could wipe out the Wall Street firms’ equity, rendering them insolvent. Leverage ratios on Wall Street reached as high as $60 of debt per $1 of equity. The managers of these firms knew (or at least should have known) that these excessive risks would sink their firms.17 Incredibly, CEO Jamie Dimon testified to the Financial Crisis Inquiry Commission, “In mortgage underwriting, somehow we just missed, you know, that home prices don’t go up forever and that it’s not sufficient to have stated income” from the borrower.18 As early as mid-2007, the Citigroup CEO stated that if liquidity dried up in the financial sector “things will get complicated” but that Citi would keep “dancing” despite the dangers, along with the entire deregulated financial sector.19 Unfortunately, even more risks emerged. The banks also made sour business and commercial real estate loans. Moreover, through a variety of

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bonuses immediately after the government extended the company a $185 billion lifeline.24 The bailouts triggered outrage from across the political spectrum. The noted financial journalist William Greider called the bailouts a “historic swindle” and fundamentally unfair because the bailouts saved the “villains” of the crisis but inflicted more pain on the “victims.”25 The former president of the Federal Reserve Bank of St. Louis termed the bailouts an “affront to the market” and an “affront to democracy” because the executives of the failed firms hauled in millions while saddling the taxpayers with trillions in financial obligations.26 The speed and scale of the bailouts suggest a fundamental problem with American democracy: The problems of the corporate class command the government’s attention regardless of economic merit, even while far more needy and less blameworthy citizens languish on the margins of the system regardless of economic potential. The economic system of the U.S. bears more semblance to crony capitalism, corporatism, or corporatocracy than to competitive capitalism. Those in control of multinational corporations seemingly enjoy windfall government largesse while ordinary citizens suffer increasing deprivation of economic opportunity. Because the inept financial elites remained at the apex of the American financial system, loan loss recognition lagged reality. Regulatory forbearance permitted the bankers to retain the toxic assets that nearly sank the system. The government never insisted that the insolvent banks recognize all losses and repair their balance sheets. As such, the bailed-out bankers still feared insolvency, which caused them to hoard massive capital. The initial withdrawal of credit thereby led to a historic contraction in bank loans that continued for years after the crisis.27 The American economy thus suffers from a “zombie” banking sector that consumes massive capital but does not lend. By the end of 2010, more misconduct emerged. When the bankers foreclosed they systematically submitted fraudulent affidavits—perjured testimony—in support of efforts to seize homes as cheaply and as quickly as possible.28 To save a few dollars in recording fees, the banks listed false nominees as mortgagees, even though others claimed to own the underlying mortgage notes.29 Often banks destroyed notes en masse rather than expend funds to track and preserve documents that bear upon real property rights.30 This misconduct means that banks threw property rights in America into a state of chaos that could well take years to repair.31 Secure and certain property rights form the foundation of every sound capitalistic economy.32 This misconduct raised the question of whether any rule of law applied to our economic system.33

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prevent those controlling great wealth from using that wealth to stifle competition and rig the economy in their favor. The subprime mortgage crisis of 2007–9 should be viewed as a harbinger of things to come if corporate and financial elites continue to dominate the U.S. economy with a view toward entrenching themselves at the cost of everyone else.45 This book catalogues the use of concentrated economic power to maintain the incumbency of corporate and financial elites at the apex of the American economy and the devolution of American law to “a system of incumbents, by incumbents, and for incumbents.”46 Instead of resources flowing to their most productive uses, corporate elites subverted government to ensure that resources flow to them regardless of productivity. Instead of law and regulation based upon sound policy and evidence, America gets distorted law and policy dictated by the interests of those in control of the largest corporations in the nation and the world. Legal or regulatory evolution based merely upon sound policy analysis yields to a devolution serving the needs of those in control of transnational corporations and banks. This reality necessarily means a chronically broken financial system and compromised macroeconomic performance, as the costs of economic privilege take their toll. Essentially, this book lays responsibility for our dysfunctional economic system squarely at the feet of those holding the greatest power over the legal structure underlying that system—a relative handful of financial and corporate elites in league with their government cronies. Following the money leads to those few in control of vast wealth. Capitalism ceased to exist in the U.S. in the wake of the failure of Lehman Brothers on September 15, 2008, on profound levels.47 Political power displaced the virtues of competition at the very heart of the American economy as elites used political power to elude the costs of their misconduct. Taxpayers, the great majority of whom had zero responsibility for the fiasco, ultimately paid massive costs as a result of the chicanery of those in charge of other peoples’ money—the financiers and the corporate titans—and will continue to pay for decades to come. Professor Joseph Stiglitz has termed this system “Ersatz Capitalism.”48 Government strove mightily to save the economy in the aftermath of the crisis, with all of the tools at its disposal— except fundamental and deep reform of our economic system. Indeed, as discussed in detail throughout this book, the Dodd-Frank Wall Street Reform and Consumer Protection Act,49 signed by President Barack Obama on July 21, 2010, implements marginal reform at best and reaffirms the power and misconduct of the financial elites at the center of the crisis at worst.50 Yet only deep reform can prevent further costly macroeconomic crises. Competition must be restored and must displace entrenchment and

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suboptimal legal infrastructure. The global economy, built upon an American vision of capitalism, propagated the financial crisis throughout the world, spreading economic misery to the four corners of the globe. American capitalism took several wrong turns, and understanding these mistakes informs the quest for a more perfect capitalism, one that admittedly is at odds with the current laissez-faire dogma permeating our culture.7 Reconstructing capitalism requires a renewed cultural bias against excessive economic power like the bias against excessive power that emerged after the Great Depression and ushered in mass prosperity along with a robust middle class. America’s potential to offer exceptional economic opportunity rests upon the ability of its legal system to curb excessive power. The Problem of Excessive Concentration of Economic Power Concentrated economic power poses serious threats to macroeconomic performance. First, those possessing excessive economic resources will rationally seek to subvert the rule of law in order to entrench their privileged position and insulate themselves from competition, at the expense of an optimal legal infrastructure to support macroeconomic growth. Second, the concentration of economic resources in the hands of a small number of powerful elites means that others—especially historically oppressed classes or minority groups—face restricted economic opportunities. Yet superior economic growth requires a society to unleash the full economic potential of its people. The combination of growth-retarding elites and large segments of disempowered citizens may threaten to destabilize the economy—especially inherently unstable financial markets—in ways that will lead to financial crises and potentially severe macroeconomic contractions. Large disparities in power among discrete groups encourage predation and exploitation in the name of profit—even unsustainable profit.8 The subprime crisis demonstrates these threats. A rationalized economic rule of law will operate to reduce concentrated economic power, to ensure basic economic opportunity for everyone, and to create sufficient regulatory and legal infrastructure to stabilize financial markets regardless of elite resistance to sound regulation. The economic rule of law must optimize incentives so that all economic actors face incentives for maximum productivity, and it must impose disincentives to discourage predation, exploitation, and disempowerment. History and economic science prove that capitalist societies require an economic rule of law (or constitution) to maximize macroeconomic growth. Unfortunately, reality differs radically from this vision of legally fragmented power, as vividly proven in

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securities laws facilitate the flow of information and lower agency costs, thereby encouraging the productive deployment of passive capital to fund risky investments. Legal infrastructure addresses inherent market flaws from asymmetric information to agency costs to manias and panics that periodically plague markets.11 Basic legal infrastructure, present in virtually every advanced economy, enjoys proof that it supports maximum macroeconomic performance. Human infrastructure in particular requires legal support to ensure that businesses can exploit a nation’s human resources to the maximum extent possible. Human infrastructure generally suffers from insufficient funding across much of the world. Funding of all levels of education generally pays for itself and facilitates every employer’s ability to generate profits through a more skilled human infrastructure. Governing elites too often underfund public education in favor of privileging their own children. This dubious tendency manifested itself in the subprime crisis through distorted global economic development and consumption patterns and an ill-educated, disempowered underclass in the U.S. The law should operate to secure the funding of human capital. In the subprime crisis, the law also failed to limit the ability of financial elites to undermine the financial regulatory system to their benefit. CEOs led their firms to originate, distribute, and invest in the riskiest subprime mortgage loans in history. Ultimately, these loans sank the global financial system, even while CEOs raked in millions. Because CEOs lobbied to reduce their accountability for negligence and securities fraud and to untether themselves from financial regulatory infrastructure, they destroyed their firms and the economy with impunity. Regulatory infrastructure must be “hardened” to resist elite subversion. At some point, powerful incumbents may rig the system so much in their favor that severe macroeconomic costs and crises result.12 The subprime crisis proves that the U.S. is now at that point. In sum, deficiencies in America’s legal infrastructure caused the subprime fiasco and its bloom into a worldwide economic catastrophe. Elite influence supplanted the rule of law and secured irrational indulgences. Our society is now paying for this lawlessness. Law and regulation reflected power imbalances instead of sound policy. Today this lawlessness continues. The Potential for an Economic Rule of Law Constitutions traditionally exist to impose the rule of law even upon the most powerful and to limit the influence of concentrated political power. In

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of war, and the judiciary does not inspect meat. An economic constitution can serve a similar function. To some extent the present U.S. Constitution already functions to ensure that proper institutional expertise controls certain issues. Congress does not debate monetary policy. The allocation of economic policy making should ensure that issues not appropriate for political negotiation meet up with institutional expertise and structures to match the complexity and importance of the issues. Certainly, an administrative body of professional economists can achieve superior monetary policy outcomes relative to Congress, which must attend to a wide array of legislative needs and which lacks any particular professional competence. History, economic and financial science, and other social science learning from around the world instead of closed-door political bargaining or partisan ideology should drive important economic policies. The current reality suggests that much political negotiation on important economic issues can hardly qualify as democratic outcomes; instead, too often political and economic insiders negotiate indulgences outside of public view. Democratic values suffer sacrifice on the altar of stealthy special interest influence and corruption. On the other hand, a depoliticized agency structure may well operate in accord with democratic expectations. For example, even the Chair of the Federal Reserve Board must reckon with congressional power to restructure the Fed and presidential power to appoint a replacement every four years. In this sense, monetary policy is not politically negotiable, but the administrative means of implementing monetary policy exists as the result of constant democratic oversight and negotiation, as successive Congresses and Presidents supervise those charged with the awesome economic power of administering independent monetary policy. An economic constitution therefore offers the possibility of superior economic outcomes without the sacrifice of true democratic negotiation. Ultimately, an economic constitution (as with all constitutions) works only when backed by cultural support. People get the rule of law they demand. So it is with an economic rule of law or constitution. Maximum economic growth requires cultural support for shifting issues toward more appropriate institutional frameworks and for resisting the power of those with concentrated economic resources. The body politic and its leaders must appreciate that certain issues are better removed from the arena of political power and toward expert policymaking organs to the extent the issue is determined not by democratic processes but by special interest influence. They must similarly recognize the economic growth potential of empowering their fellow citizens. The point is to insulate key issues from the influence of concentrated economic power. This will happen only if a given culture demands it. Law can reflect this cultural

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starting in the 1980s lifted restrictions on the ability of the financial sector to originate, distribute, and invest in more risky assets than ever before. Elites convinced governments to allow their firms to become “too big to fail.” This lowered the cost of capital for such firms and encouraged more risky conduct. The focus became maximizing short-term profitability (and thus bonuses to senior executives) even while saddling our financial sector with huge risks of staggering losses. Ultimately government did in fact bail out the firms, effectively extending government guarantees to executive compensation agreements and other unsecured creditors. Bank executives won big.20 Most shareholders suffered huge losses. This extension of government welfare to the most powerful and reckless in our society belied free market rhetoric that operated to deny government assistance to the most needy. It also made a mockery of the great mythological American meritocracy. Instead of rewards and responsibility flowing to the most able, government acted to rescue the most irresponsible, inept, and reckless. One wonders exactly how such executives and managers achieved their positions in the first instance. Ability and character seem irrelevant to advancement in the American economic system. Instead, crony capitalism infects the apex of the American economy. The flood of financial losses that followed in the wake of this debacle caused a historic contraction in credit in the context of a historically overleveraged U.S. economy. Indeed, the economic and political interests who effectively control the process of globalization rigged it to rely upon massive debt for its survival because that alone temporarily spurred consumption in the face of lower wages (and higher short-term profits) for transnational corporations. Corporate elites co-opted the legal structure of globalization to generate more profits built on cheap labor for transnational firms. As jobs moved overseas to cheap labor locales, durable buying power vanished. Lowwage jobs displaced high-wage jobs. Capital could move freely under this so-called neoliberal regime, but labor remained trapped in low-wage locales. The profits generated by this low-wage model of globalization enriched executives at transnational firms, but, in order to prop up demand for their products, Americans, as consumers of last resort, needed ever higher levels of debt to maintain consumption. This model of globalization left much of the world’s population disempowered and economically marginalized. Globalization made little provision for economic development to support wider-based consumption. Thus, the low-wage model of globalization relied on cheap production abroad and consumption centered in America where debt supported growing consumption even in the wake of lower wages. This proved unsustainable.

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legal infrastructure that the possibility that America is mired in an inequality trap cannot be dismissed. Disrupting an inequality trap is difficult. Nevertheless, there is some cause for optimism, because the U.S. has a unique historical appreciation for curbing unlimited power through the rule of law, and the greatest experience with making capitalism work. Unfortunately, the first American effort for reform, the Dodd-Frank Wall Street Reform and Consumer Protection Act,22 failed to produce fundamental reform. While Dodd-Frank empowers regulators to break up large financial firms, there is no mandate for regulators to exercise this power, and in the past regulators facilitated the aggregation of economic power on Wall Street. The law makes only a cursory effort, if that, to address power imbalances within America. No regulatory agency will enjoy any further structural protections from special interest influence under the Act. Certainly, Dodd-Frank ends the deregulation march of the past thirty years, but much of the regulation effort remains in the hands of the very regulators who led that march. Thus, the law appears too timid and modest, unless regulatory authorities and the Obama administration use their newly minted powers with a level of urgency and aggressiveness that heretofore has seemed missing. This book highlights the macroeconomic toll of allowing the economic and political power of elites to operate with insufficient legal restraint and of allowing oppression to fester. A corollary to this reality is explored in the Epilogue. Specifically, the Epilogue addresses the economic potential of an optimal legal infrastructure, an optimal distribution of economic opportunity under law, and the imposition of optimal legal constraint on the most powerful elements of society. Such an economic constitution would greatly enhance social justice and move society toward Rawlsian notions of social justice, in a pragmatic sense. By definition, empowering the most disempowered would unleash the greatest benefit to macroeconomic growth.23 Consequently, enhanced social justice in the current global economic context will lead to massive macroeconomic benefits. This reality is possible under a reconstructed capitalism that distributes economic power in accordance with competitive norms rather than raw political power and crony capitalism. Chapter 1 articulates a new Law and Economics framework to supplement the current neoclassical paradigm that dominates the field and proved inadequate in the context of the subprime crisis. It builds upon the recent revolution in macroeconomics that entails the scientific study of growth dynamics and institutions that facilitate growth. This represents a challenge to law: how best to identify and structure interventions that can operate to enhance economic growth. Human capital development and market development prove

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depoliticized financial regulation is needed to correct the inherent instability of financial markets. CEO power figures prominently in the distorted legal framework governing globalization, as examined in full detail in chapter 4. As Joseph Stiglitz highlights, the legal structure of globalization can be understood as “thinly veiling special interests” that, in fact, dominated the evolution of globalization.25 If free market ideology dictated the course of globalization, then it would make provision for the free movement of labor as well as the free movement of capital. If economic growth dictated the course of globalization, then legal infrastructure and human capital formation would be legally secured. Instead, the construction of globalization emphasizes capital liberalization and ever cheaper labor, without any means of mitigating inherent economic instability arising from these values. This leads to the massive destruction of buying power, and the destabilization of capital markets. The accumulation of dollar reserves (among other currencies) stoked an enormous credit bubble in the U.S. (and ultimately Europe) that overwhelmed regulators. The subprime crisis proved the unsustainability of this system of globalization. Chapter 5 addresses traditionally oppressed groups. Generally such status inherently results in the massive destruction of human capital and limits the extent of the market. This analysis starts with the recognition of the irrational basis of such oppression and the operation of malicious social constructs to always and everywhere support the wanton and pervasive destruction of human capital. Any society that continues to tolerate such mechanisms of disempowerment (including but not limited to race and gender) suffers stunted macroeconomic performance. On the other hand, a nation that seeks to overcome disempowerment and embrace the diversity of experiences and perspectives of traditionally oppressed groups will achieve superior cognitive insights as well as the breakdown of groupthink and homosocial reproduction. In the U.S. today, race continues to operate to disempower large segments of the population and to create artificial social distance that empowers elites. The reality of race in America contributed to the full array of legal infrastructure infirmities that led to the subprime crisis—and following the massive flow of wealth from the most disempowered in the U.S. to the most powerful inexorably indicts the continued sway of race in America as a key driver of the crisis. Law and regulation alone will never fully prevent economic crises; capitalism always remains vulnerable to swings in human psychology that cause inherent financial instability. Globalization and financial innovation amplify this infirmity. This means that legal frameworks must be in place to deal with

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inherently threatens individual autonomy and liberty. A larger government may become corrupted and transmogrify into an instrument of oppression. This laissez-faire political philosophy is not addressed in this book. Rather, this book simply shows that such an austere vision of government intervention ignores the macroeconomic damage caused by excessive elite power. Further, laissez-faire philosophy ignores the gains in individual autonomy and liberty caused by state disruption of concentrated economic power. Poverty in particular is anathema to any reasonable definition of liberty, and an optimized macroeconomic environment supported by law empowers everyone. As the Nobel laureate Amartya Sen highlights: “Development requires the removal of major sources of unfreedom: poverty as well as tyranny, poor economic opportunities as well as systematic social deprivation, neglect of public facilities as well as intolerance or overactivity of repressive states.”26 Thus, legal infrastructure in support of human capital development and maximal economic performance operates as a great net liberating force. Regulatory infrastructure by definition leads to frameworks that cost less than the economic benefits produced. The focus of this book is to spotlight and detail legal frameworks supported by evidence showing that benefits exceed costs and to articulate a means of durably securing such beneficial regulation through law while maximizing economic opportunity for everyone. Capitalism delivers powerful economic and social benefits to societies that pursue its logical ends. Adam Smith, however, long ago recognized: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public or in some contrivance to raise prices.”27 More pointedly, he stated that “whenever the legislature attempts to regulate the differences between the masters and the workman, its counselors are always the masters.” Therefore, “when the regulation is in favor of the workmen . . . it is always just and equitable; but it is sometimes otherwise, when in favor of the masters.”28 He also stated that the government role in a market economy includes “maintaining those public institutions and public works, which, though they may be in the highest degree advantageous to a great society, are of such a nature, that the profit could never repay the expense to any individual or small group of individuals.”29 Finally, he argued, “The expense for institutions of education . . . is likewise, no doubt, beneficial to the whole society, and may, therefore, without injustice, be defrayed by the general contribution of whole society.”30 Smith’s vision of capitalism thus comprehends the need to curb those with economic power, to secure infrastructure, and to encourage human capital formation. Rationalization of these elements, within the framework of sound legal infrastructure to support capitalism, forms the foundation of this book. It

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infrastructure must address these challenges through means that raise the return to capital or lower the cost of capital, just as a superhighway may permit trucks to last longer and deliver more goods in shorter time. Elites will not naturally seek optimal market infrastructure if they can profitably rig unregulated financial markets in their favor. Law must secure rationalized human capital formation, market development, and regulatory infrastructure in order to maximize macroeconomic performance. Stunted human capital formation, market development, and legal infrastructure form the root causes of the financial crisis of 2007–9. Global growth rested excessively upon American consumption because governing elites put little effort into market development elsewhere. American consumption rested upon an infirm foundation of debt, as corporate elites relentlessly moved jobs from the U.S. to low-wage locales, eroding middleclass buying power. Ultimately capital flows from developing nations to the U.S. funded highly exploitative debt—predatory and subprime loans to the most disempowered elements of society. Excessive American debt exploded and crashed the global economy. Law facilitated this exploitative pattern of global finance. Corporate elites profited mightily from these flows because corporate governance permitted compensation arrangements that created incentives for senior managers to take reckless risks. Elites distorted law to achieve irrational indulgences from traditional notions of accountability for fraud and due care. Although the system collapsed, financially, in the fall of 2008, the basic structure persists and seems destined to produce further economic pain. Law could disrupt this reality. Unfortunately, Law and Economics (as taught in American law schools) retains a moribund focus on market efficiency, narrowly interpreted to mean laissez-faire principles, with no emphasis on macroeconomic growth. Indeed, the work of economists regarding the endogenous factors associated with growth does not even warrant a mention in two primary Law and Economics texts. Essentially, law schools taught generations of legal policymakers that growth does not matter to law and that law does not matter to growth, despite the learning from economics. This empowered elites to hide behind laissez-faire dogma to justify the elimination of legal and regulatory constraints. Thus, an economic revolution went by unnoticed by law. The Law and Economics canon rested upon shaky economics and even shakier history. This would lead to devastating consequences in the context of the subprime debacle. Law must comprehend the full breadth of economic learning—including macroeconomics.15 Traditionally, economics said little about growth. Traditional economic models deemed the dynamics of growth exogenous—growth fell from the

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founded upon environmental degradation simply shifts costs to future generations. Such growth is illusory at best and can impose staggering long-term macroeconomic costs in the form of diminished human capabilities at worst. Growth nevertheless appears more sustainable than many imagine. The right kind of policies can enhance economic growth and environmental sustainability simultaneously.20 More than 200 years ago, Thomas Malthus predicted that population growth would outstrip earth’s resources.21 History shows that Malthus simply underestimated human ingenuity.22 Human ingenuity is perhaps the exclusive means of dealing with environmental challenges. Second, not all economic activity benefits society. Most notably, in the U.S. massive resources support the criminal justice system, yet the U.S. incarcerates more of its citizens than any nation on earth. This certainly signals a social malignancy inconsistent with social well-being. Excessive prison expenditures may enhance short-term growth, but only at the cost of any reasonable measure of aggregate social happiness—a society that imprisons many of its citizens suffers from either an abnormally high concentration of dangerously violent people (unlikely) or an out-of-whack criminal justice system.23 Mass incarceration (along with accompanying stigmatization) fails to maximize human productivity, notwithstanding the short-term impact on macroeconomic output that prison-related expenditures may generate.24 Third, other measures of social well-being beyond per capita GDP may prove more insightful. For example, the United Nations annually assesses national development through its Human Development Index. The index includes life expectancy, educational attainment, inequality, and GDP per capita as four dimensions of development. As of 2011, twenty-two nations scored higher than the U.S.25 In general, however, economic growth is an important consideration and one measure of the well-being and quality of life within a given society. Sustainable macroeconomic growth gives society the resources necessary to address longevity, education, and other elements of well-being. Countries with higher GDP enjoy longer life expectancy, better health, more leisure, and higher educational attainment. Modern capitalist societies deliver astonishing social outcomes without historic precedent. In Great Britain, over the past 200 years average height has increased by 3.6 inches. In the U.S., the average work week plunged since 1870 and the prospect of retirement soared, even as previously unaffordable amenities became widespread. Meanwhile, real GDP per capita increased sevenfold. “A Japanese baby born in 1880 had a life expectancy of 35 years; today life expectancy in Japan is 82 years.”26 The spread of capitalism served to lift 200 million Chinese citizens out of poverty over 20 years, from 1981 to 2002. The number of

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loom. Capitalism, properly reconstructed, constitutes the most powerful means yet discovered of unleashing human ingenuity. “There is no reason to expect slackening in the rate of output through exhaustion of technological possibilities.”32 Indeed, shortages of resources seem unlikely to stifle growth as high prices automatically encourage searches for substitutes.33 There is no reason why alternative energy platforms (such as solar energy) cannot form a nonrivalrous source of growth (as the Internet functioned) to stir innovation through lower cost and cleaner energy.34 Once such a network is in place, the costs of additional use are very small compared with the network’s ability to spur innovation by increasing the returns to capital. In other words, new ideas can save the environment and support more innovation rather than leave humanity in permanent economic downturn.35 Environmental damage simply does not wash away past growth gains, and mitigating the cost of damage to the environment could well spur positive growth, much like massive public works projects or the government’s investment in the creation of the Internet. This book is premised on the notion that further environmentally sustainable growth is possible, even highly probable. In fact, such growth may well provide the exclusive path out of environmental degradation. The central point of this book concerns the potential for legal frameworks to create a more robust capitalism, a capitalism that minimizes the power of elites to subvert competition and maximizes the power of all to enter competitive markets in accordance with their highest economic potential. Capitalism operates to support longer, healthier, more enlightened lives than ever before in human history. Consequently, the prescriptions herein seek to optimize capitalism through law, not its abandonment or radical redesign. The reconstruction of capitalism merely means pursuing the lessons from economic history to their logical ends in the context of a modern knowledgebased economy to support maximum human empowerment. The Revolution in Economics A revolution occurred in the world of economics during the past few decades.36 Specifically, the study of economic growth exploded in the field of economics.37 It started with Solow’s residual in 1957 and accelerated after Professor Paul Romer’s two landmark papers Increasing Returns and Economic Growth38 and Endogenous Technological Change.39 Economists sought to endogenize the key factors driving economic growth—technological change—into economic models. They concluded that technological advances drive growth, ideas drive technological advances, human capital development

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workforce will adapt to new technologies with greater facility.48 Empirical evidence shows that enhanced cognitive skills among workers will enhance macroeconomic performance, particularly when economists screen out unproductive human capital investments undertaken in corrupt nations where economic prospects dim.49 Recently, economists have shown that skills development (as opposed to years in potentially unproductive schools) constitutes the “key” issue facing developing nations, where skills are generally “truly dismal.”50 Powerful empirical evidence demonstrates positive macroeconomic spillovers from a more educated workforce.51 Wages for all levels of education seemingly rise as more college-educated workers enter the labor force.52 Social returns further include lower crime and incarceration rates.53 Higher levels of education also lead to superior health outcomes.54 All of this means that the social returns to education exceed just the private returns, which raises the prospect of underfunding for educational attainment in the absence of government action.55 The college wage premium, however, increased across the globe in recent decades, meaning that the demand for college graduates exceeds the supply of college graduates.56 Therefore, government funding fails to meet the economic thirst for educated workers. Additional financing challenges threaten educational investments. Imperfect financial markets seek to lend based upon social connections and collateral (i.e., wealth) instead of academic promise, which can be difficult to observe and verify. Without access to wealth or finance, many poorer children must forgo education.57 Even in developed nations, such as the U.S., credit constraints seemingly play a major role in the inability of many students to complete college.58 These credit constraints combined with the excess public returns to education mean that without vigorous government action, educational funding—and by extension innovation and economic growth—languishes, particularly for disempowered groups. Thus, a major longitudinal study over a period of twenty years shows that eighth-graders in the U.S. with high scores on standardized tests but from low-income families attend college at less than half the rate as high scorers from high-income backgrounds. Further, rich students with low scores attend college at ten times the rate as low-scoring students from poor backgrounds.59 These impediments to financing education carry real consequences. In the U.S., the most influential factor determining an individual’s socioeconomic status is the socioeconomic status of that individual’s parents; family wealth holds far more sway than even so-called IQ tests, which themselves suffer infection from socioeconomic circumstances, as discussed in chapter 5.60 Similarly, economic mobility—the ability of an individual to achieve

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similar challenges assessing the appropriate level of antitrust law enforcement, where simultaneity issues render efforts to endogenize antitrust enforcement problematic.72 Expanded funding for education can facilitate the creation of useful ideas without the drawbacks of changing either competition law or intellectual property law. Professor Romer extended the power of ideas further when he recognized that some ideas serve as platforms for the generation or transmission of more ideas; he terms these ideas meta-ideas. Thus, patent law, the Internet, and the modern research university all exemplify the power of metaideas.73 Notably, meta-ideas usually require legal frameworks, as meta-ideas generally enjoy public funding. For example, the U.S. government founded the Internet.74 Romer’s work helped to create an entirely new field of macroeconomics termed Endogenous Growth Theory or the New Growth Theory. Endogenous Growth Theory provides a key lesson that animates this book: Ideas support growth through increasing returns to scale. Simply put, ideas about new ways of doing things, once formulated, cost nothing and thereby drive economic returns ever higher when deployed in larger and deeper (i.e., more prosperous) markets. Meta-ideas hold the potential for achieving increasing returns across the entire economy. Education creates the possibility of new ideas and insights and thus constitutes the ultimate meta-idea. Yet productivity in the educational sector in the U.S. lags. According to the Organisation for Economic Co-operation and Development (OECD), the U.S. spends as much as any major industrialized nation. Nevertheless, the high school graduation rate in the U.S. (at 77 percent) falls far below the OECD average.75 In 2009, the U.S. ranked twenty-first in secondary school graduation rates.76 Educational outcomes in the U.S. seem destined to worsen: The OECD’s current assessment shows the nation’s fifteen-year-olds scoring lower than those in thirty-one of thirtytwo developed nations in math and faring well below average overall; and a recent ranking of the best universities in the world showed that those in the U.S. typically cost tens of thousands of dollars per year more than comparably ranked foreign universities.77 These stark facts support only one conclusion: The U.S. under-invests in education and fails to use its resources effectively. Given the centrality of ideas to economic growth, the U.S. abdicated economic leadership over the past twelve to fifteen years. Recently economics suffered criticism for its failure to predict the depths of the financial crisis of 2007–9. Economists generally failed to provide guidance on the macroeconomic dangers of excessive debt, uncontrolled predation, leveraged asset bubbles, the dangers of perverse incentives, and the problems posed by undercapitalized banks.78 Nevertheless, certain lessons

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permitting greater specialization or product differentiation and creating more room for growth. The value of ideas is not really a function of market size so much as effective demand. Market depth logically operates to drive profitability as much as market size.81 The insight that a broader middle class creates demand for more innovation commands broad empirical support.82 The upshot of the importance of market size combined with the fact that labor productivity is dependent upon market prosperity suggests government responsibility for market maintenance. Government should see to it that the foundation of consumption is maintained. The starting point for these efforts must focus on human capital formation because that alone forms the basis for durable buying power in a globalized economy. The GI Bill, which President Franklin D. Roosevelt signed in 1944, more than doubled the number of college graduates in the U.S. between the beginning of World War II and 1950. Congressional estimates suggest a payback ratio of up to $12 for every dollar the government expended for the GI Bill, based solely upon the enhanced income of recipients.83 Similarly, the Guaranteed Student Loan Program and other financial aid programs from the 1970s operated to deliver $4.30 for each dollar invested because of enhanced income.84 Nevertheless, the trend in the U.S. suggests that college education costs are outpacing government financial aid and that college affordability has declined in the U.S. in recent years.85 The problem of affordability of higher education explains the fading U.S. advantage in higher education. It also evinces a short-sighted governing elite as human capital development spurs both innovation (supplying innovators) and market development (demand for innovation). During the Great Depression, the U.S. demonstrated the efficacy of supporting steady and robust consumption. The National Labor Relations Act facilitated unionization, which in turn facilitated a robust middle class with secure employment. Social Security freed consumers from the worries of sustaining themselves through retirement and unleashed further consumption. The New Deal also empowered consumers to purchase homes like never before; indeed, the New Deal ushered in the thirty-year mortgage, which became the bedrock of the American middle class.86 Beyond the New Deal, the Civil Rights Act of 1964 moved a significant portion of the population from the economic margins of society to the threshold of the middle class. Every one of these government initiatives subsidized growth: They created consumers committed to high levels of expenditure and continuing employment; they expanded both the consumer base and the pool of skilled, committed employees for every business; and they expanded the ability of every American business to allocate its fixed expenditures across a wider consumption base. The New Deal tripled America’s middle class.87

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system of government regulation serves as a foundation of macroeconomic growth and stability. Basically, legal and regulatory infrastructure should seek to lower the cost of capital or raise the return to capital, throughout the economy. If law can achieve such an end, then the economic benefits of government intervention likely will greatly exceed the costs of intervention, in terms of compliance or transaction costs. All government action implies transaction costs or compliance costs, even if only in the form of taxation or the cost of legal counsel. Yet lowering the cost of capital or raising the returns to capital across the economy certainly spurs innovation and entrepreneurial activity on a wide scale. Thus, interventions can support macroeconomic growth. Of course, identifying and structuring such interventions may prove challenging. Economic science can help. Usually, economic science analyzes interventions in general terms only rather than testing specific legal or regulatory approaches or language. Further, a model is only as powerful as its assumptions. Similarly, because correlation is not causation, economics must reckon with issues relating to the direction of causation, possible exogenous factors to a given study, as well as data quality. Insights from economics nonetheless may form powerful mosaics that serve to guide the structure of law and regulation. Other social sciences also may serve to support and illuminate successful government interventions in favor of economic growth. History, in particular, can serve to support lessons from economics or to dispel economic myths. Law changes over history, and understanding the historic impact of legal changes can provide insights on how law should structure interventions into the economy. Bringing all social science evidence to bear on the question of how precisely government can best support the economy may well achieve the best possible outcome given the inherent limitations of economic science. Notably, this interdisciplinary approach also supports a superior platform than the current approach of Law and Economics, which too often relies heavily on theory and even speculation over a balanced view of economic science as tested in the cauldron of history and other social sciences.94 I relied on history as well as modern economic science in 2003 to assess the efficacy of the New Deal seventy years after President Franklin Roosevelt assumed office. While some elements of the New Deal failed, other elements provided a solid foundation for future growth. The New Deal created legal and regulatory infrastructure to support the operation of free markets (particularly financial markets) and to lower the cost of capital or raise the return to capital. These elements supported macroeconomic growth for seven decades, uninterrupted by major financial disturbances. From securities

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crunch hit the global economy. The lesson Gorton draws: New regulation is needed to facilitate the operation of the shadow banking system, making it less vulnerable to runs.98 The dismantling of much regulatory infrastructure played a central role in the crisis of 2007–9. Chapter 3 reviews the main elements of financial deregulation that led to the crisis. Here, the key point is simply that government intervention in the market can spur growth. The securities laws lower the cost of capital by inspiring investor confidence and raise the return to capital through more diligent management. Deposit insurance lowers the cost of capital by eliminating the risk of bank runs from the retail banking system, greatly stabilizing the economy and allowing bankers to loan money to business at more generous terms. Unfortunately, governing elites, in thrall to laissez-faire, ignored history—that finance requires regulatory infrastructure if it is to thrive—and risked an avoidable financial meltdown. That risk persists unabated today. Legal infrastructure may also secure appropriate human capital development. Recently economists discovered that refined data sets lead to more robust links between human capital development and economic growth.99 Those studying China’s remarkable growth record over the past thirty years attribute much of its economic performance to its “quite rapid” development of its human resources.100 It expanded literacy by 7 percent in one seven-year period and quadrupled educational expenditures over seventeen years. With respect to the so-called East Asian Miracle of growth during the 1980s and 1990s, human capital development again figured prominently.101 The nation that best secures human capital development under law will no doubt enjoy the greatest economic success in the globalized economy, which handsomely rewards innovation. I address the most promising legal frameworks for securing human capital development in chapter 7. Legal infrastructure must also cabin excessive economic power. Here the subprime crisis of 2007–9 speaks loudly. The subprime crisis arose from the “money-driven American political system.” Campaign contributions and lobbying influenced the repeal of the Glass-Steagall Act, the decision to deregulate the derivatives market, the ability of financial firms to use leverage to enhance current profitability at the expense of longer-term risk, and the use of balance sheet vehicles to hide risk and create illusory profits—profits that failed to appear when risks manifested themselves in real losses, among other regulatory deficiencies.102 The bailouts associated with the crisis also reflect the influence of money over sound policy. The rule of law requires that legal frameworks supporting economic growth be secured from the often pernicious influence of governing elites.

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find abundant historical evidence that in both instances powerful elites subverted law and harmed macroeconomic performance. The authors next test the proposition through a constructed index of the rule of law to determine if nations with weak legal systems suffer impaired growth. They find that inequality is “bad for growth” in countries with a weak rule of law.108 Thus, the law must account for the subversion of legal regimes arising from high levels of inequality. In 2004, on the occasion of the fiftieth anniversary of the Supreme Court’s landmark decision in Brown v. Board of Education that American apartheid must end (with “all deliberate speed”),109 I surveyed evidence related to inequality and growth and concluded that inequality arising from the oppression of minorities continues to harm economic growth through the destruction of human capital. I argued in favor of mitigating racial inequality within the U.S. through enhanced funding for human capital formation. Because racial hierarchies draw zero support from science, their existence necessarily evidences economic oppression.110 The modern U.S. is hardly exempt from the threat that economic inequality may reflect the operation of illegitimate economic hierarchies that lead to impaired human capital formation. Far from finding any kind of immunity, economists recently demonstrated that in the past, high inequality compromised human capital formation in the U.S.111 Other researchers find high excess returns (of 11 to 15 percent) to state educational outlays, particularly in high-inequality locales.112 The U.S. therefore appears prone to the same dynamic that economists identify in other nations: Governing elites will not fund appropriate human capital formation for the children of others under conditions of high inequality.113 Historically, land inequality operated to impede human capital formation in the U.S. and abroad while land reforms and egalitarian land ownership gave rise to enhanced educational outlays.114 Mancur Olson articulated The Theory of Collective Action to explain the mechanism underlying elite subversion of law. Large, diffused groups face the temptation to free-ride, based upon the assumption that others will press government to vindicate their interests. Small groups with concentrated interests and resources do not fall prey to the same temptation and may coordinate their efforts without the dilution of their interests as implied in freeriding problems.115 Naturally, high inequality means more resources in fewer hands and leads to smaller groups with more concentrated interests. Olson’s theory has been extended to explain the behavior of legislators in seeking out issues that attract the interests of concentrated groups so that lawmakers may exploit their lower costs of organization and attain higher levels of campaign contributions, or other largesse, such as future employment. Although

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2007 (prior to another historic financial catastrophe). According to Saez, this increased concentration of income arises from “an explosion of top wages and salaries” particularly among top corporate executives.118 These facts mean that more of our nation’s resources are more concentrated in fewer hands than ever before. Such a high level of income concentration encourages “investment” in rent-seeking subversion of law. More concentrated wealth reduces collective action costs. It also allows concentrated elites access to more resources. At some point, the increase in access to resources leads to increased access to political leaders, with all the consequent implications regarding cognitive and cultural capture. Ultimately, economic and political elites homogenize, as revolving doors in government and business lead to a high velocity of exchange between government and business leaders. As the real economy atrophies (when elites attend more to the indulgences of cronies than to facilitating growth), investment opportunities dwindle and rent-seeking opportunities from governmental subsidies and legal indulgences attract further investment. In the U.S., the damage to the rule of law is evident in its current ranking of fiftieth in the world in trust in politicians and the ability of the government to deal with the private sector at arm’s length.119 Professor Simon Johnson and James Kwak document precisely these mechanisms in the context of the subversion of financial regulation in the run-up to the subprime fiasco. First, the concentration of economic resources of the six largest commercial and investment banks within the financial sector surged from under 20 percent of GDP in 1995 to over 60 percent in 2009. Second, from 1990 to 2006 campaign contributions soared from $61 million to $260 million, while lobbying expenditures reached $3.4 billion. Third, the leaders of the Wall Street firms and the policymakers in Washington, D.C., shuttled between the two power centers seamlessly until the mindset of the two melded into the same antiregulation, pro–financial sector mantra. Finally, the compensation paid in the financial sector soared. From 1980 through 2007 the financial sector successfully freed itself from a wide array of regulations and consolidated to the point where a handful of mega-banks exerted inordinate control over the economy.120 Chapter 3 reviews the parade of regulatory indulgences in the financial sector, but this pattern of elite subversion of regulation pervades this book and transcends the financial sector. Control of corporate wealth—within the financial sector or otherwise— unlocks concentrated power. CEOs now dominate the public firm in the U.S.121 CEOs use the prodigious wealth within their corporations to sway law and regulation in a direction that serves CEO interests. In recent years, senior managers have amassed massive annual compensation and used

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Economic evidence cannot definitively establish that economic inequality always leads to deficient legal institutions and impaired growth.130 In addition to the usual problems of endogeneity, simultaneity, and possible omitted variables, more data would be required to establish when inequality becomes threatening.131 This book adds clarity to this important issue by tracing the use of elite influence on law and following the elite profits as well as damage to the general economy in the specific context of the financial crisis of 2007–9 and its ongoing economic impact. In the end, the potential that high inequality may exact a macroeconomic toll suggests that the law should mitigate the means by which this toll is paid by society at large. Empowering the disempowered will naturally mitigate that potential, as will rational market development. Similarly, sound regulatory infrastructure will operate to curb the exercise of economic power. These elements each benefit from an independent economic justification, as discussed previously. In any event, the underlying causes of the subprime mortgage crisis furnish compelling evidence on the pernicious economic influence of excessive elite power, through the failure of governing elites to ensure rational human capital and market development as well as their subversion of law. Human capital formation is a central issue of excessive elite domination. One may easily imagine that a highly educated population would enjoy sufficient capabilities that the democratic negotiation of market development and regulatory infrastructure would yield optimal macroeconomic outcomes. Further, a reallocation of economic opportunities toward the disempowered would necessarily mitigate inequality. Empowering the most disempowered axiomatically yields the greatest economic benefits. Thus, human capital formation may rightly constitute the prime goal of legal and regulatory infrastructure. In chapter 4, I discuss economic human rights in depth as an example of an ineffective international legal framework for securing human capital formation, and in chapter 7, I discuss historic episodes in the U.S. that triggered elite commitment to human capital development. The Failings of Neoclassical Law and Economics Neoclassical Law and Economics (synonymous with neoliberalism and market fundamentalism, because of its emphasis on market efficiency) postulates that all regulation interferes with the market’s ability to allocate resources efficiently, and the more austere the role government plays in the economy, the better.132 As Professor George Priest highlights, the Law and Economics movement originated as a political philosophy rather than as the application of economic science to legal problems and issues.133 This approach dominated

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of law to entrench their relative position. It ignores the need to search for appropriate regulatory and legal infrastructure. In short, it ignores every key element of dynamic macroeconomic growth. For example, the primary Law and Economics text on the eve of the crisis, The Economic Analysis of Law, by Judge Richard Posner, simply assumed that market efficiency will also maximize economic growth regardless of distributional considerations. The text failed to address the necessity of regulation in the financial sector and instead simply suggested that all regulation is inefficient.140 Earlier editions termed employment, inflation, and output “mysterious macroeconomic phenomena.”141 Posner opined that legislation and regulation should be presumed economically inefficient.142 He incorrectly stated that economists “widely accepted” that the securities laws do not help investors, claiming that “securities regulation may be a waste of time.”143 Even those texts taking a broader approach to Law and Economics fail to substantively address distributional considerations and fail to address the law’s role in securing institutions necessary for economic growth.144 Law and Economics as taught in law schools across the U.S. holds that market efficiency constitutes the primary focus of law insofar as economics is concerned, and this essentially operates as a throwback to laissez-faire. Very recently, Judge Posner, to his credit, modified many of his views. Rather than dismiss macroeconomics as “mysterious,” he now recognizes that law and regulation centrally influence macroeconomic performance. Judge Posner identifies the “withering” of financial regulation as an underlying cause of the subprime debacle and what he terms the descent into depression. He now recognizes that an “intelligent” government must keep the economy “from running off the rails.” To be fair, Judge Posner by his own admission is not a macroeconomist. Moreover, high-profile macroeconomists such as the Nobel laureate Robert Lucas thought that modern monetary policy had slain severe economic downturns. Therefore, perhaps the conventional Law and Economics movement could be forgiven for its sanguine attitude toward risky deregulation and its agnosticism toward distributional issues.145 Still, a revolution must occur in Law and Economics so that legal policymakers can exert sway over the evolution of the legal system with the full perspective of economics and growth—and Judge Posner’s most recent edition of the Economic Analysis of Law (2011) fails to significantly change course from his prior volumes notwithstanding the financial crisis of 2007–9.146 Generations of legal minds and policymakers have been inculcated in this dogma. Law and Economics served to imbue lawyers with misguided ideology parading as sound economic policy. Posner’s epiphany may prove

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humans no matter their potential. In order to construct a capitalism that secures maximum human productivity, a different set of assumptions must take hold, different from those that secure market operation. The concept of maximum human productivity requires optimal incentives and disincentives under law, and opportunities allocated in accordance with economic merit. Finally, the macroeconomy in general must support maximum economic opportunity. Idealized markets fail to attend to these basic needs for maximum economic opportunity. The idealized conditions for maximum growth instead require the total elimination of competitive privilege and competitive disempowerment. Each and every element of economic privilege leads, axiomatically, to an element of disempowerment suffered by some victim of the unfair privilege—a victim deprived of the ability to compete on the basis of merit. Privilege also breeds arrogance and hubris within the recipient, which invariably undermines effort to compete. Economic disempowerment leads to hopelessness and discouragement, which similarly undermines efforts to compete. Privilege as well as disempowerment corrodes human productivity, and the perfect elimination of both privilege and disempowerment essentially forms the foundation of a vision of perfect competition that maximizes productivity and thus macroeconomic growth. The elimination of privilege necessarily means that elites lack power to subvert law and regulation—that they are essentially rule takers as opposed to rule makers. If law can evolve free of elite subversion, then the law ought to impose ever more refined economic institutions to secure growth. In the absence of elite ability to subvert law and regulation, legal frameworks should inspire maximum confidence among elites as well as non-elites in such a way as to maximize incentives to invest. Therefore, if all economic actors face the law as equals, with no ability to prospectively or retroactively change law in their favor, or to undermine accountability, then all actors can achieve maximum productivity in a legal environment as conducive to growth as possible. The current vision of perfect competition holds that resources must enjoy perfect mobility—that is, that there are zero transaction costs. But suppose transaction costs yield more in economic benefits than the cost. For example, given the power of the federal securities laws to enhance investor confidence and encourage more diligent management, the lower cost of capital and higher returns to capital associated with the federal securities laws apparently yield much higher benefits than the costs imposed. The maximization of human productivity assumes government support of the macroeconomy, and that means that all cost-justified government interventions occur and that all non–cost-justified interventions do not occur. In other words,

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Viewed in this manner, legal infrastructure is no different from other types of infrastructure. Legal infrastructure should operate to raise the return to capital or lower the cost of capital. The Subprime Crisis All of these failings in mainstream economic thinking came together to create an economic tsunami in 2007–9 (and beyond) that revealed in vivid detail the flaws in the neoclassical paradigm. Elites freed themselves from basic economic regulation, particularly financial regulation. The corruption reached depths that at one point in our history would have been unthinkable: The law provided insulation to securities fraudfeasors instead of legal penalties; the law operated to insulate directors from any duty of care; policymakers eliminated basic consumer protection at the behest of lobbyists representing the most powerful interests in society; historically oppressed groups were laid disempowered at the economy’s fringes, begetting a vicious episode of economic exploitation that proved costly economically as well as morally; globalization spawned massive debt for elite profit; and taxpayers faced an extortion of epic proportions under the guise of the doctrine of “too big to fail.” These distortions created tremendous economic costs that remain incalculable even years after the start of the crisis. Indeed, the crisis spawned even more massive misallocations of resources than existed before the crisis commenced. A perverse socialism for the rich and powerful seized the commanding heights of the American economy. We live in an economic Dark Ages relative to our potential, and law provides the key meta-ideas to facilitate our transition out of this morass. The world teems with unexploited human potential and unharnessed ideas. The fact that 2.6 billion (almost one-half) of the world’s population subsists on less than two dollars per day proves this central point.153 Such a reality leaves too much potential brilliance untapped, too many ideas locked into poverty. Moreover, it understates the issue to focus only on deep poverty; in the U.S., there are private high schools that expend almost $65,000 per pupil, compared with an average expenditure of about $9,000 at public high schools.154 If economic logic supports educating the children of the wealthy so exorbitantly, it also supports similar efforts to educate the children of the disempowered. No such effort exists in the U.S., where educational attainment has stagnated (at best) from 1980 to the present.155 Even in developed economies, human potential languishes at the margins of the economy. The problem with such a deep chasm in human capital formation is that it encourages predation—as social distance increases, power disparities lead to precisely

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The Promise of the Modern Public Corporation Corporations function to facilitate the flow of passive capital to productive investment and entrepreneurial uses. Small pockets of capital that otherwise would require expensive intermediation through financial institutions may instead directly fund economic growth through the purchase of shares of stock issued by publicly traded firms. Facilitating this flow of capital fuels investment, entrepreneurship, and innovation.14 If public share markets are well developed, then investors can enjoy the benefits of risk diversification, which further lowers the cost of capital.15 Nations with more developed financial markets naturally enjoy more growth in capital-intensive industries.16 Today, a broad economic consensus holds that well-developed capital markets with widely dispersed share ownership consistently appear in successful modern economies and enjoy a close association with superior economic growth.17 The modern public corporation appears essential to macroeconomic growth because it holds the promise of lowering the cost of capital. Five key legal elements undergird this function. First, limited liability protects passive investors from any liability for corporate obligations, shielding them from unnecessary risks. Second, shareholder claims on the corporation, including its assets, are transferred to freely trading shares, meaning that the firm need not concern itself with the possibility that its owners (or their creditors) could disrupt operations by calling back capital.18 Third, centralized management means that shareholders are legally stripped of all control over the firm (save electing directors) and cannot bind the corporation improvidently; instead, managers control the firm through their expert business judgment.19 Fourth, shareholder primacy (which at least rhetorically means that the corporation should be operated with the primary goal of expanding shareholder wealth) gives shareholders confidence that they will benefit from the fruits of their investment.20 Fifth, perpetual existence gives the corporation a very long investment horizon, making it the ideal means of holding long-lived assets.21 Each of these elements gives the corporation a capital-raising advantage, by eliminating risks or creating potential economic benefits. Shareholder primacy lies at the core of the corporation because the point is to attract capital at a lower cost, and any move away from shareholder primacy likely would defeat this purpose. All of this allows the corporation to operate as the perfect capital aggregator under law.22 None of these elements imposes costs upon society because shareholders do not have power over the firm, and the duty to manage the firm rests with a board of directors that, at least theoretically, owes a duty of care to the corporation. If a shareholder cannot control a corporation—which the law

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The corporation stands as a powerful example of legal infrastructure. The legal innovations associated with the corporation lower the cost of capital throughout the economy. These innovations create an institution every modern capitalistic society needs: an entity that can soak up the passive savings generated by individuals with neither the interest in managing nor the expertise to manage a business venture. The creation of a centrally managed firm with the ability to hold long-lived assets proves critical to macroeconomic performance. Virtually every successful economy relies upon these innovations to mobilize passive capital and fund innovation and entrepreneurship. Extending limited liability to passive investors and assuring them that the entity will focus upon their enrichment serve to eliminate risks to investors and lower the cost of capital. If the corporation did not exist, it would need to be invented. Lowering the cost of capital empowers entrepreneurs and spurs innovation. As such, the corporation functions as what the economist Paul Romer terms a meta-idea—an idea that serves as a platform for the economic actualization of other ideas.27 This explains why commentators term the corporation the “greatest single discovery in modern times.”28 Other commentators go further. They state that the corporation is the “most important organization in the world” and “the best hope for the future of the rest of the world.”29 The power of the corporation to facilitate investment, innovation, and entrepreneurship boosts macroeconomic growth. In an ideal world, the corporation would operate as a capital aggregator for the best, most economically powerful ideas. The corporation would do this without regard to race, gender, or class. A powerful capital aggregator would meet powerful ideas. This vision challenges the law to optimize the corporation. Getting governance right would be a step in the right direction. The problem with the corporation lies not with its essential elements but with deeply suboptimal corporate governance law.30 The Costs of CEO Primacy Without appropriate mechanisms to contain agency costs at either the federal or state level, corporations degenerate into weapons of mass economic destruction. Agency costs arise inherently from any agency relationship wherein one person commits to act on behalf of another. Such costs can arise from theft, shirking, dishonesty, negligence, or miscommunication. “[I]t is generally impossible for the principal or the agent at zero cost to ensure that the agent will make optimal decisions from the principal’s viewpoint.”31 The problem of agency costs plagues the corporation, which separates ownership

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managers—such as poison pill provisions, staggered boards, limits on shareholder bylaw amendments, and golden parachute arrangements—contributed powerfully to diminished returns.40 Strengthening investor protection laws would lead to more dispersed ownership because of incentives to diversify. Lower investor protection encourages concentrated ownership, as investors forgo diversification benefits to control agency costs. Superior investor protection regimes support a lower cost of capital, including the benefits of more dispersed ownership. Ownership of equity securities seems far too concentrated worldwide, suggesting that investors forgo the benefits of diversification in favor of the power to control agency costs.41 Investors provide more capital at a lower cost if they face lower risk of loss from agency costs and may enjoy the benefits of diversification. That fundamental insight enjoys broad if not unanimous empirical support.42 The subprime mortgage crisis demonstrates the losses that CEO primacy can inflict upon society under financial stress. The U.S. system of corporate governance did not perform well as the real estate bubble emerged and then burst. The global financial meltdown showed that “checks and balances at each level of the corporate hierarchy broke down.”43 Strong evidence demonstrates that CEOs at such firms knowingly exposed their firms to very high risk of failure even while collecting hundreds of millions of dollars in compensation. Agency costs spun out of control within the key public firms at the center of the crisis during 2007–9. The entire global economy absorbed huge losses, but the CEOs at these firms enjoyed huge windfall paydays.44 For example, the nation’s largest mortgage lender, Countrywide Financial, entered into the largest predatory lending settlement in history in 2008, agreeing to over $8 billion in loan modifications to resolve lawsuits brought by eleven states. The states alleged that Countrywide misled borrowers regarding fees, costs, and risky loan features. Former employees corroborated many of the allegations, including the fact that Countrywide steered borrowers into subprime loans even though they qualified for prime loans. The firm’s CEO, Angelo Mozilo, earned total compensation (much from the exercise of stock options) of $102 million in 2006 and $229 million in 2007. This includes $127 million that Mozilo took in from the exercise of options in 2007, the same year that Countrywide announced massive mortgage losses. Shareholders lost 80 percent of their share value before Bank of America acquired the firm. Ultimately, Bank of America recognized $33 billion in loan losses arising from its acquisition of Countrywide.45 The Financial Crisis Inquiry Commission (FCIC), a congressionally authorized commission charged with investigating the financial crisis, found that as early as 2006

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The basic pattern transcends the details of each company. CEOs and senior managers rang up short-term profits at the cost of undisclosed and excessive risks. Shareholders lost vast wealth. Global financial markets crashed and taxpayers bailed out CEOs and other managers (as well as unsecured creditors). The regulators across the financial system—banking, insurance, mortgage lending—failed to use their powers to stem the recklessness. Merrill Lynch (the largest securities firm) and Washington Mutual (the largest savings and loan or thrift) evince the same basic pattern of vast losses for all but senior managers.53 In fact, the New York Times commissioned a study of compensation at the seven firms at the epicenter of the crisis (all of the above-mentioned as well as Bear Stearns and Lehman Brothers). Their findings echo the above. “Executives at seven major financial institutions that have collapsed, were sold at distressed prices or are in deep to the taxpayer received $464 million in performance pay since 2005.”54 Yet, these same firms lost $107 billion and shed $740 billion in shareholder value between 2007 and 2009.55 The CEOs of these firms received compensation for profits that quickly transmogrified into cascading losses. Nevertheless, the executives faced little or no prospect of liability and owed no obligation to repay their “performance pay” when the profits turned to losses that sunk their firms.56 The deputy director of the Council of Institutional Investors, Amy Borrus, stated, “Poorly structured pay packages encouraged the get-rich-quick mentality and overly risky behavior that helped bring financial markets to their knees and wiped out profits at so many companies . . . yet many of these C.E.O.’s have pocketed enormous compensation.”57 CEOs and other managers enjoyed sufficient autonomy to inflict massive agency costs upon shareholders, trigger a global financial crisis, and still achieve huge pay for themselves. As one bank CEO, Jamie Dimon, candidly stated, “In mortgage underwriting, somehow we just missed, you know, that home prices don’t go up forever and that it’s not sufficient to have stated income.”58 According to Dimon, the entire fiasco arose from reckless management: “I blame the management teams 100% and . . . no one else.”59 Scholars studied the degree of loss senior executives suffered as a result of lost share value. Most executives do in fact hold significant shares in their own company. The study of compensation for the top five senior executives at Bear Stearns and Lehman Brothers found that while the executives made billions from the sale of stock (as well as in salary) from 2000 to 2008, shareholders faced massive losses. The managers pocketed large amounts of incentive compensation, both from bonuses and stock sales, during the years immediately preceding the failure of the firms. “As a result, the bottom line

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lead naturally to a legal system that favors the rich and powerful.69 The highly pro-CEO law of corporate governance fits these theories of special interest power better than any race-to-the-top or race-to-the-bottom thesis. CEOs enjoy economic and political resources superior to those available to the investing public.70 Economists recently created testable models showing how such interests outweigh interests with a stake in more optimal corporate governance standards.71 That reality manifests itself across corporate governance law and regulation. Joel Seligman warned in 1990 that legal constraints upon CEOs and other corporate managers evinced excessive laxity. He stated, “The most distinctive aspect of the last decade in corporate law was the celerity with which traditional constraints on corporate managers weakened.”72 Dean Seligman’s analysis turns on three facts. First, the restriction on shareholder suffrage rights arising from an SEC rule change permitting dual class voting for listed shares threatened to allow management to dilute shareholder voting power. Second, limitations on shareholder derivative litigation diluted managerial accountability in court for breach of fiduciary duty. Third, the decline of hostile takeovers as a result of constitutionally permissible antitakeover statutes removed a major threat to management’s control. Each of these mechanisms for managerial entrenchment developed over a relatively short period of time before 1990.73 Since 1990, further laxity has emerged. Federal Law Failures to Control Agency Costs Prior to the Great Depression, corporate governance law and regulation operated free of federal intervention and provided scanty shareholder protection. For example, public corporations owed no continuing obligation to disclose anything to their shareholders absent an affirmative request that could be defeated in litigation. This system allowed agency costs to fester and ultimately proved unstable. Federal law intervened to remedy the most egregious shortcomings.74 As part of the New Deal, Congress enacted the Securities Act of 193375 and the Securities Exchange Act of 1934,76 on the basic premise of the power of disclosure.77 “Sunlight is said to be the best of disinfectants; electric light the most efficient policeman.”78 These federal laws required for the first time that public firms periodically disclose all material facts as well as audited financial statements to their shareholders.79 Unfortunately, Congress betrayed these basic and time-tested laws in the 1990s. The Acts extended robust remedies to deceived investors over preexisting state law. Indeed, for several decades after the enactment of the securities laws the courts broadly interpreted remedies available under the federal

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as accountants. It is the first time that actual securities fraudfeasors benefit from any type of safe harbor. This is the reason one commentator termed this provision a “license to lie.”93 It is difficult to imagine a more reactionary revision of the New Deal than these provisions. Yet a bipartisan coalition enjoying overwhelming support in Congress followed up in 1998 with the Securities Litigation Uniform Standards Act (SLUSA),94 which preempted state law liability for securities fraud involving public corporations when relief is sought for shareholders generally in the form of a class action.95 Traditionally, the federal remedies that investors enjoyed under the federal securities laws operated cumulatively with state law remedies. This meant that federal law could only strengthen the rights of investors. After SLUSA, federal law now operates to give perpetrators of securities fraud special protections not available under state law. Given that widespread securities fraud can potentially wreak havoc on the economy, this special protection for securities fraudfeasors represents an irrational departure from traditional norms of accountability. Unfortunately, the odd protections of federal law for corporate managers do not stop there. The federal proxy rules, promulgated under the Securities Exchange Act of 1934, impose a system of corporate democracy reminiscent of “democracy” in Stalinist Russia. Under state law, shareholders elect directors. Dispersed ownership, however, typically means that a public firm must solicit shareholder authorization to vote via proxies (rather than in person at the annual shareholder meeting), and those proxy votes determine the election. Current management will solicit proxy votes routinely, and the director-candidates in practice are therefore nominated by management. Management’s slate will run essentially unopposed, unless a shareholder also solicits proxy votes on behalf of shareholder nominees. This process involves much expense and generally requires legal counsel. These costs must be borne by the shareholder. Management’s proxy solicitation will be funded from the corporation’s coffers, meaning that shareholder wealth essentially funds both sides of a proxy contest.96 Management’s proxy solicitation could act as a vehicle for contested elections if shareholders had access to it for shareholder nominees for the board.97 The SEC, however, has long blocked shareholder access to management’s proxy solicitation for the purpose of director elections.98 Disrupting management’s control of the proxy machinery could mitigate the negative effects of CEO primacy. Empirical evidence shows that firms which nominate directors without CEO involvement outperform other firms with CEO involvement.99 Although the SEC frequently discusses the possibility of proxy reform, it never approves broader proxy access. Occasionally the SEC floats a proposal to reform so-called corporate democracy, but

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Court found that FIRREA diminished accountability for federal bank managers under federal law, to gross negligence only.113 After FIRREA, federal law operated to relieve directors of longstanding and traditional notions of accountability for negligence. At the time of the Supreme Court’s decision, a government study identified director laxity as a prime cause of the crisis. The total cost of the crisis approached $1 trillion. Thus, in 1996 I predicted that excessive laxity in the standard of care owed by bank managers would lead to more costly bank crises.114 On very simple issues, federal law operates to entrench management. It makes no sense to allow managers to select directors. It makes no sense to eliminate traditional notions of accountability for fraud. Federal law entered the field of securities regulation in order to enhance the rights of investors and in order to restore “ancient” norms of accountability for those managing other people’s money; therefore, it is senseless for federal law to betray its traditional purposes and preempt state law notions of accountability.115 Federal law shifted during the 1990s from a source of enhanced accountability for corporate elites to a source of enhanced indulgences. These indulgences represent extreme deviations from traditional norms of accountability. Although special interest influence may be “well hidden,” the fingerprints of massive lobbying expenses appear pervasively throughout the dilution of federal standards of accountability.116 Consequently, these indulgences appear to suffer from such deep irrationality that they subvert the rule of law—they reflect elite power to evade traditional principles of accountability generally applicable to all other economic actors. State Law Failures to Control Agency Costs The political structure applicable to corporate governance law at the state level further erodes basic accountability within the public corporation. Corporate federalism denotes the unique power allocation between federal and state law with respect to corporate governance for publicly held corporations. Traditionally, federal law operated (primarily through the federal securities laws) to fill in manifest gaps in state law. These federal initiatives apply to all publicly traded corporations. State law provides general corporation laws and charters corporations. The internal affairs doctrine requires that the state which incorporated the firm also supplies the substantive law governing the internal operation of the firm, including corporate governance law and standards. Most public firms incorporate in Delaware and thereby become subject to Delaware corporate governance law. Firms incorporate in Delaware because (among

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This narrow zone of liability functioned effectively (along with robust securities fraud remedies) to rein in corporate elites and limit agency costs to minimally acceptable levels. No major macroeconomic disruption linked to corporate governance occurred for seven decades. Today, it is fair to say that corporate elites face zero exposure to liability for the breach of the duty of care. Instead, those occupying the commanding heights of our economy may be infinitely careless and face no monetary sanction. One study found only one confirmed case resulting in payment of monetary damages since 1980.120 The story of the death of the duty of care in the public corporation boardroom is the story of how political power can be wielded to obtain legal indulgences not generally available to all. The Delaware Supreme Court’s 1985 decision in Smith v. Van Gorkom marks the starting point for the shift to CEO primacy.121 The Delaware Supreme Court found that the director-defendants in that case breached their duty of care notwithstanding the business judgment rule by acting in a grossly negligent manner. The Smith decision supposedly shocked directors. The insurance industry also feigned shock, as if they had no idea directors could be found liable for breach of the duty of care, even though the insurance companies took in premium income for assuming that very risk. In any event, insurance industry interests, combined with management interests, lobbied for the end of the duty of care.122 The Delaware legislature (or, more precisely, the representatives of the large law firms of Wilmington, as discussed above) responded with section 102(b)(7), which for the first time authorized a Delaware corporation to eliminate the duty of care for directors pursuant to a provision in the articles of incorporation.123 Under our federal proxy system, management can easily amend the articles of incorporation; thus, this change in Delaware law meant the “evisceration of the duty of care.”124 Within two years, more than forty jurisdictions followed suit. The duty of care for the American public corporation died. In fact, no reported decision since Smith holds a director of a public firm liable for breach of the duty of care.125 The CEO, however, Jerome Van Gorkom, certainly acted with gross negligence. Van Gorkom initiated negotiations to sell the firm without conferring with the board. He set the price for the sale without any expert analysis of the firm’s value. The board met to approve the merger but attached an important condition: They insisted that other firms could bid for the company to create an auction.126 Unfortunately, CEO Van Gorkom, an attorney and a CPA, signed the merger agreement (drafted by the purchaser) without reading it and without sharing it with the board or other senior officers. Instead of facilitating an auction for the company, the agreement (and a subsequent

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scandals did not trigger any financial meltdown. The public corporation generated steady increases in shareholder wealth. Unfortunately, as memories of the Great Depression faded, so did elite commitment to maintaining appropriate legal infrastructure within public firms. Ultimately, easy profits trumped the attractiveness of sound corporate governance. From 1985 through 1998 corporate and financial elites used political power to free themselves from traditional constraints and thereafter plundered public corporations, again and again. Corporate executives of large public firms constitute a small group with large stakes in corporate governance of public firms. Shareholders face temptations for free-riding on the lobbying efforts of others, owing to their vastly greater numbers and their reduced stakes relative to those of managers, whose livelihood is on the line. Further, managers control shareholder wealth held within corporations and may access that wealth to lobby against shareholder interests while shareholders must expend their own funds. The theory of collective action would not predict much success in curbing CEO autonomy under these circumstances. Indeed, at both the state and federal level CEOs have fared better than shareholders over the past few decades, until CEOs enjoyed so much power that the system now puts the interests of the CEO above that of the shareholders. This expansion of CEO power under law coincided with soaring CEO compensation. In 1980 the ratio of CEO pay to that of the average blue collar employee was 42:1, and in 2000 it was 475:1.133 By the cusp of the crisis, the enhanced power of CEOs over their firms led to compensation that far outpaced not only wages of ordinary workers but corporate profits as well.134 Similarly, as of 2008, CEO pay in the U.S. exceeded CEO pay in Japan by a factor of ten, and a factor of two in Europe.135 American corporate governance law simply leaves too much power in the hands of the CEO, and that power leads directly to excessive compensation relative to historic CEO pay or CEO pay under other legal systems. Agency Costs in Historic Perspective Courts strived to contain agency costs generally for centuries outside of corporate law prior to the subprime debacle. The culmination of these efforts forms the basis of the Restatement (Third) of Agency, which was drafted by a variety of legal experts (judges, law professors, and practicing lawyers) to reflect and summarize controlling common law principles for agency–principal relationships. An agent must exercise ordinary care on behalf of a principal. An agent owes broad disclosure duties of material information. The

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of potential duty of care liability and exposure to securities fraud sanctions secured the basic economic mission of the modern public corporation. A number of scholars argue in favor of such proposals.142 Despite the corporate scandals of 2001–2, the options-backdating scandal, and the subprime fiasco, however, no significant political effort to roll back the legal indulgences granted to corporate elites has materialized. Nevertheless, other proposals may ultimately prove more politically sustainable, given the trillions that investors plow into corporate America annually. CEO primacy takes an intolerable economic toll within the investor class. The latest episode of CEO autonomy run amok crashed the entire global financial system. Further overreaching holds the possibility of well-designed reform.143 For example, the New Deal professionalized the securities brokerage industry, including competency exams, sanctions, and self-regulatory oversight.144 Given the power of corporate managers and their ability to inflict trillions in costs upon society, it is odd that they are not subject to any similar regimen of accountability. Holding corporate elites to professional norms of ethics and competence makes economic sense. Corporate managers should be forced to take competency and ethical examinations in order to retain their positions of power. If they violate professional norms and standards, they should face disbarment, fines, or similar sanction. This would effectively mandate professional management of the great wealth held in public corporations. Meritocracy would displace cronyism. Substantial support already exists for the concept of professionalizing corporate governance. Ira Milstein, a prominent and respected New York corporate practitioner, proposed enhanced professional standards for the board of directors in 1995. Milstein concluded that the continued acceptance of the corporation as the locus of economic activity necessitates “increasing professionalism of directors” complete with ethical standards and a gradual displacement of amateurs.145 Since 1995, other voices have joined Milstein’s call for increased professionalization of corporate governance. A group of concerned MBA students (working under the supervision of Professor Rakesh Khurana) from the Harvard Business School wrote a Public Policy Proposal for the Corporate Governance College in April 2009. They argue that corporate governance lags behind the “intensely complicated” business environment. They propose the creation of a nonprofit and private directors’ college that could serve as a clearinghouse for high-quality directors prepared to serve on boards. The students call on regulators or Congress to mandate that certain “at-risk” companies seat three such directors on their boards. Other firms could participate voluntarily with the hope that market pressure would create demand for directors certified by the corporate

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a limit on the total percentage of corporate manager representation on the governing board. Other board seats, say 75 percent, should be reserved to shareholder representation, institutional investors, and academics from economics, finance, and law. Post-employment restrictions, long terms, and generous compensation (all part of the Fed’s structure) must form a part of the depoliticized structure of the corporate governance agency. Most important, the agency must enjoy a self-funding mechanism to free it from congressional appropriations and influence.155 The goal requires the curtailment of CEO autonomy and the use of the best available science to set corporate governance standards. Standards would be based upon learning and experience from across the world rather than upon the interests of managers holding political power. Institutionally, the Delaware legislature appears hopelessly captured and unwilling to attend to controlling agency costs. Congress fares little better, granting special legal indulgences even to securities fraudfeasors. Similarly, the federal court system as presently structured operates to entrench privilege rather than to curb the exercise of economic power, a point I address further in coming chapters. An expert agency could enforce standards with refined precision. For example, typically corporate managers do not pay money out of their pockets for their wrongdoing. The business judgment rule cut off almost all liability for negligence. In Smith v. Van Gorkom, after the Court actually assessed liability, the Delaware legislature essentially abolished the duty of care. This result obtained even though no director or officer in Van Gorkom paid a penny in liability.156 Only in exceptional cases did corporate directors or officers ever pay money out of pocket for any liability.157 This system secures neither deterrence nor compensation. An administrative agency, on the other hand, could impose fines calibrated to the degree of culpability of the individuals responsible for, or participating in, securities fraud or other misconduct. Calibration eliminates the need to reduce substantive legal standards of accountability in order to avoid a disproportionate assessment of damages that may amount to billions in losses. Calibration also involves a careful assessment of professional misconduct under the watchful eye of professional peers, or alternatively an expert administrative agency. This approach closely mimics current professional regulation regimens.158 Service as a senior executive or director of a public firm brings status and wealth. The most powerful members of society serve as directors. Former cabinet members, ambassadors, and senior federal officials serve as directors of public firms. Therefore, there is little prospect that restoring accountability of corporate elites would cause a diminution in the number of those willing

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from the flawed framework governing the public corporation’s supervision of the audit function. Consequently, audit reform assumed a center stage in the SOX reforms. All of this effectively stripped the CEO of autonomy over the audit function. The SOX reforms of the audit function appear successful. Independent audit committees are associated with a lower cost of capital.167 Business scholars suggest the SOX approach (as refined by SEC regulations) is “optimal” because it allows firms flexibility in defining the precise contours of the audit committee. Independent audit committees appear to facilitate higher-quality audits. The SOX reforms therefore operate to enhance the quality of audits and reduce improper earnings management.168 Moreover, it is noteworthy that in the context of the subprime mortgage crisis, audit failure has not materially contributed to the subprime crisis.169 The problem revolved around the manipulation of risk, not the accounting system. SOX audit reforms, therefore, appear to enhance the operation of corporate governance. Using the SOX audit reforms as a model, I recently argued that further organic changes to the legal structure of corporate governance would constitute one appropriate response to the subprime fiasco. Specifically, I proposed an independent committee of the board to manage enterprise-wide risk-management policies. I also suggested a mandate that firms create an independent Qualified Legal Compliance Committee, to oversee the legal risk and compliance risk of public firms. Finally, I suggested an expansion of recent efforts to remove the CEO from the process of selecting board members. This suggestion would require not only an independent nominating committee that would nominate director candidates without CEO input but also shareholder nominees, selected by the independent nominating committee, to run in contested elections. All of these suggestions focused on eliminating excessive CEO autonomy over non-operational activities. CEOs would remain free to pursue strategic visions and implement appropriate tactical operations. The board would simply exercise enhanced oversight.170 These reform proposals responded to the vacuum Delaware creates in its command over the evolution of corporate governance law. Delaware dominates the business of chartering publicly traded firms; indeed, Delaware behaves like a monopolist in this field. As such, Delaware can afford to ignore the issue of controlling agency costs, which could alienate management interests holding control of incorporation decisions. The need to maintain its revenue stream from franchise taxes paid by firms incorporated in Delaware acts a prime motivating factor of Delaware policymakers. Thus, Delaware harbors little interest in allowing corporate law to evolve in response to

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blitz on financial regulators complete with an army of recently hired ex– financial regulators.175 These interests viewed the 2010 midterm elections as an opportunity to correct the harshest reform measures within the Act and spent millions in campaign contributions to influence lawmakers.176 Indeed, business interests quickly stymied SEC efforts to give shareholders access to management’s proxy to nominate directors in the courts.177 The Dodd-Frank Act likely simply offers yet another chance for financial and corporate elites to subvert legal and regulatory infrastructure and leave America with underdeveloped corporate governance standards. The stunted development of corporate governance law in America leads to massive misalignment of incentives for corporate elites. Instead of focusing on shareholder wealth maximization, they focus on short-term compensation payouts. The direct economic costs of CEO primacy amount to trillions, as shown by the impact of the Enron and subprime crises on shareholder wealth. That marks only the beginning of the costs of dysfunctional corporate governance law. In the following chapters, I show that the unbridled power of CEOs operated to compromise legal and regulatory infrastructure regarding financial regulation, globalization, and other legal and regulatory infrastructure. CEO primacy creates unacceptable costs across a range of issues. Finally, given the recent U.S. Supreme Court decision in Citizens United, CEO primacy left undisturbed likely will spawn more problems. If concentrated economic power spawns distorted legal and regulatory infrastructure as well as stunted human capital development, then the largely unencumbered power of a small number of CEOs and senior managers at the apex of the greatest aggregations of capital in history (U.S. public corporations) constitutes a potentially lethal economic threat to the continued viability of capitalism.

3 Animal Spirits and Financial Regulation There is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on . . . animal spirits. John Maynard Keynes (1936)1

So long as free capital markets permit all holders of assets to sell at once, a risk of panic looms. For example, an exogenous shock such as the terrorist attacks of 9/11 can deter all buyers and cause financial markets to crash. Human psychology (or “animal spirits”) influences investment decisions and as such injects inherent instability into the financial system. Financial markets consequently suffer from cycles of boom and bust. Booms encourage corporate and financial elite complacency, regulatory laxity, and public dormancy.2 Further, with respect to financial regulation, corporate elites seemingly always oppose regulation without regard to its macroeconomic benefits. Elites even opposed the federal securities laws, claiming that “the grass will grow on Wall Street.”3 Apparently elites would rather operate free of legal and regulatory constraint than create a regulatory environment conducive to growth, and therefore they bitterly oppose any regulation.4 The financial crisis of 2007–9 shows the macroeconomic costs of regulatory failure, particularly regulatory failure to account for the influence of concentrated financial and corporate elites with control of concentrated economic resources.5 This 74

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means that regulatory infrastructure must be structured pursuant to legal frameworks designed to meet these challenges. According to the economists Thomas Ferguson and Robert Johnson, the “money driven American political system” drove “every phase of the crisis.”6 A steady drumbeat of deregulation, nonregulation, and misregulation paced the entire causal chain of the financial crisis. Financial elites stood behind the apparently inept regulators and the laissez-faire lawmakers, garnering windfall profits even while saddling the global financial system with enormous losses. From campaign contributions to lucrative job offers, financial elites held sway over lawmakers in ways that vividly illustrate the costs of runaway inequality. For example, Clinton Treasury Secretary Robert Rubin headed Goldman Sachs and led President Clinton’s efforts to raise money from Wall Street interests. He subsequently spearheaded the effort to repeal the Glass-Steagall Act and ended up as the Vice-Chair of Citigroup, the greatest beneficiary of the repeal, raising ethical questions.7 Although some hoped otherwise, nothing much changed with the Obama administration, as Peter Orszag went from member of the Obama cabinet to Vice-Chair at Citigroup, the largest federal bailout recipient.8 On the GOP side, Senator Phil Gramm of Texas pushed for derivatives deregulation and the repeal of the Glass-Steagall Act. He ended up as Vice Chair of UBS. While a senator, Gramm received more support from the financial industry than any other.9 His wife, Commodity Futures Trading Commission (CFTC) Chair Wendy Gramm, also worked to ensure the nonregulation of derivatives, which permitted Enron to engage in dubious transactions. She found herself on the Enron board of directors.10 Financial elites hedge their political investments to ensure bipartisan access and influence. They win regardless of election outcomes. This chapter first shows the nexus of political influence, elite self-interest, and the subversion of legal and regulatory infrastructure in finance. By 2007, these connections led to an unprecedented concentration of wealth within the financial sector with all the adverse implications for law and regulation.11 Next, the chapter seeks solutions in the form of durable legal and regulatory frameworks. Unfortunately, the political prospect for financial regulatory reform dims in the face of increased concentration of wealth within the financial sector, increased CEO power over the public corporation, and general increased concentration of personal wealth held primarily by corporate and financial elites.12 On the other hand, further foreseeable, deep, and painful macroeconomic disruptions could induce the American voting public to repudiate unbridled wealth and lawless concentrated economic power once and for all.

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regulatory powers over many subprime lenders. Nevertheless, between 2003 and 2007, at the height of the subprime storm, the Fed brought just a single enforcement action related to subprime lending, levying a $70 million fine against Citigroup. The Office of the Comptroller of the Currency (OCC), as primary regulator of all national banks, and the Office of Thrift Supervision (OTS), as primary regulator of all federal thrifts, similarly ignored problems at national banks and thrifts. Regulators opted for lax enforcement of lending standards rather than risk losing “client” financial institutions to more permissive regulatory schemes. The OCC and the OTS each depend upon fees levied against constituent banks. In fact, Countrywide’s banking subsidiary switched to a thrift charter in 2007 to take advantage of more lax regulation.23 Thus, Bair’s call for regulation fell on deaf ears. In the backwater of this regulatory neglect, subprime lending exploded, increasing fivefold between 2001 and 2005. By 2006, 40 percent of all mortgage-backed securities (MBS) included at least some subprime loans.24 Inevitably, problems emerged. The problems, according to Bair, involved the financial literacy of subprime borrowers (many of whom were subject to America’s subprime educational system for disempowered classes), adequate disclosure of the true costs and risks of subprime loans, and the dispersal of risks through securitization of loans to investors across the global financial system.25 Bair claims that the profits available to all from subprime lending created a political vacuum in Washington in support of any regulation and that regulatory frameworks allowed compensation incentives to be focused too much on the short term. The profits in subprime lending delayed any reasonable regulation until long after the crisis advanced to a critical stage.26 In the meantime, the most economically powerful within our society continued to exploit the most disempowered at considerable profit.27 Ability to repay indebtedness and abusive costs generally defines the line between subprime lending and predatory lending. If generating fees and high-interest payments displaces the object of loan repayment, then the loan evinces predation. Asset-based lending, wherein the lender looks to underlying collateral for repayment rather than borrower income, similarly indicates a predatory intent. Steering prime borrowers into subprime loans, with higher costs, also suggests predation. Fraud marks many predatory loans.28 Predatory lending lies at the core of the current financial crisis. Securitization facilitates predatory lending because the original loan may shift the risk of default to the end-investor. Subprime loans flowed via securitization to investors across the world so the originators lacked incentives to underwrite the loans in terms of credit risk. This exacerbated the predatory nature of the lending.

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as mortgage-backed securities (MBS) in the 1970s. This added liquidity to the home mortgage market and expanded capital available to fund home mortgages. The GSEs maintained sound underwriting standards and experienced the lowest default rates in the mortgage business. In the 1990s, Clinton administration officials determined that Fannie and Freddie should invest in subprime mortgages to expand home ownership. The GSEs ultimately facilitated the creation of an entirely new MBS market for subprime loans.40 In 2004, the Bush administration ordered Fannie and Freddie to adhere to expanded affordable housing mandates.41 They invested $434 billion in subprime mortgages (through MBS originated in the private sector) between 2004 and 2006. Thereafter, the GSEs cut back their subprime investments. By 2007 their total subprime investment constituted only about 15 percent of the total subprime MBS outstanding.42 Competition from private banks rendered Fannie and Freddie increasingly irrelevant in the subprime mortgage market.43 The GSEs did not invest in the riskiest subprime loans, as evidenced by the modest $3 billion loss suffered on such investments from 2008 through 2011.44 One scholar stated the role played by Fannie and Freddie (as investors) well: “[T]hey were suckers.”45 Yet the bipartisan decisions to push the GSEs into subprime mortgages fueled subprime lending’s initial profitability, opening the door to abuse.46 As the subprime market developed, the banking industry enlisted the federal financial regulators in a campaign to free themselves from the strictures of state law. In 2004, the Office of the Comptroller of the Currency, the primary regulator of national banks, preempted state efforts to regulate predatory lending. This followed the earlier effort at the Office of Thrift Supervision to do the same, with respect to all federally charted thrifts such as savings banks and savings and loans.47 The U.S. Supreme Court joined this effort (under heavy lobbying in the form of amicus briefs) and upheld the ruling of the federal regulators that preempted state predatory lending restrictions applicable to subsidiaries of banks and thrifts.48 Federal law therefore operated not only to permit predatory lending but also to denude state efforts to crack down on predatory loans. Subprime lending festered in this deregulatory environment. The states proved more interested in imposing legal sanctions than any federal regulator. Countrywide Financial, for example, settled the largest predatory loan in history, agreeing to more than $8 billion in loan modifications, in a suit pressed by eleven states.49 The states charged that Countrywide paid its agents to steer borrowers into riskier, high-cost loans and inflated borrowers’ incomes (without borrower involvement) so that they could qualify for larger, more profitable loans. Countrywide also misled

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The unfortunate consequence of all this led directly to the origination of massive subprime mortgages. Those mortgages, resting on a foundation of fraud and predation, infected the entire global financial system through derivatives. Derivatives Nonregulation Banks created a variety of instruments that derived their value from pools of subprime mortgages. These derivatives played a key role in the subprime debacle of 2007–9 and continue to haunt the global economy today. Derivatives are simply contracts that derive their value from reference to some other asset. Only the imagination of financial experts and the capacity of computer programs limit the complexity of derivatives. The financial engineers on Wall Street created ever more convoluted versions of derivatives that ultimately depended upon subprime mortgages for their value—ranging from credit default swaps to collateralized debt obligations. Whatever the label, the underlying value of many of these derivatives depended upon the performance of subprime mortgages.57 The total lack of regulation of these derivatives burdened our financial system with excessive risks, to the breaking point. The story of Brooksley Born, former Chairwoman of the Commodity Futures Trading Commission (CFTC), tellingly illustrates the ability of those with concentrated economic power to evade important regulatory infrastructure necessary to support financial markets. From her position as the first female president of the Stanford Law Review, Born rose to become an internationally reputed attorney, specializing in derivatives law. Many derivatives contracts, like stock index futures, are traded in open exchanges such as the Chicago Board of Options; over-the-counter derivatives contracts trade privately, meaning only the parties to the contract know of the existence or terms of the contract. Financial institutions generate income from derivatives in the form of transaction fees as well as trading profits. To the extent that the value of derivatives springs from a complex mathematical model requiring complex computer programs, an investment firm may enjoy enhanced pricing capability relative to a plain vanilla instrument, as more complex instruments create unique pricing opacity.58 Such complex derivatives typically trade in opaque over-the-counter markets. These unique market advantages created accompanying risks. Even firms as sophisticated and well resourced as Procter & Gamble found themselves unable to control the risks of trading in derivatives. P&G sued Bankers Trust for $100 million in losses resulting from derivatives trading in the 1990s.59

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The market for over-the-counter derivatives soared to $595 trillion by 2007. When the credit crisis fully bloomed in late 2008, financial markets had no means of knowing which firms had what exposure to the failure of other firms, or the deterioration in value of which securities (or which subprime MBS). Raw panic shut down credit markets. Born’s nightmare became reality. The risks of massive and unknown exposures pursuant to over-the-counter derivatives rendered every major financial institution suspect in global financial markets. Eventually the U.S. government stepped in and committed trillions to prop up the entire financial sector. According to Joseph Stiglitz, “[I]t is absolutely clear to me that if we had restricted the derivatives, some of the major problems would have been avoided.” Stiglitz states that unfortunately voices within the Clinton administration felt the need “to make the world safe for Goldman to sell derivatives in Korea.”64 In late 2009, Born warned that the failure to close the regulatory gap relating to over-the-counter derivatives will lead to further financial cataclysms. Warren Buffet, perhaps the most successful investor in the world, called derivatives “financial weapons of mass destruction.”65 Derivatives played a major role in the subprime crisis, the Long Term Capital Management crisis, and the Enron debacle. Yet, they persist, and they persist without any real regulatory infrastructure at all. Today, the notional amount of derivatives outstanding approaches $1 quadrillion.66 This represents giant wagers on sovereign debt, interest rate movements, the financial vulnerability of a wide array of firms, commodities, currencies, and a host of other computer-generated elements.67 Today, an even more painful financial disruption looms, arising from European sovereign debt and bank deleveraging, sending creditors scurrying for the protection of U.S. Treasury obligations and other safe havens.68 Derivatives and the uncertainty they breed will exacerbate this crisis and further damage the real economy.69 As John Maynard Keynes said in 1936, “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”70 This bizarre reality exists only as a testament to the political power of financial elites. Derivatives produce profits, and profits produce compensation payments. Further, the dizzying array of derivatives of dizzying complexity permits financial executives greater latitude to manipulate earnings, hide losses, and create illusions of profitability. Thus, Enron infamously traded derivatives to generate profits but hid losses from such trading in offbalance sheet entities. Derivatives trading formed the core of Enron’s business. Combined with more than 3,000 special purpose entities, Enron used derivatives to hide large losses, to hide debts, and to inflate the value of firm assets. Essentially, derivatives allowed Enron to use sophisticated financial

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Theoretically, they faced incentives to assess accurately the credit quality of subprime MBS. Higher-quality credit rating agencies could, for example, seek to build a reputation for integrity that could inspire greater investor confidence in their ratings, leading to competition based upon quality. In reality, however, the investment banks (the issuers of subprime MBS) selected and paid the ratings agency for rating a particular subprime investment. Internal conversations among employees of rating agencies confirm that the prospect of losing business from the investment banks for unfavorable ratings treatment drove the agencies to dilute their risk assessments.78 Former analysts testified before Congress that the investment banks would shop the MBS from agency to agency until the rating conformed to the demands of the issuer. In response to an internal survey, one ratings agency executive stated, “These errors make us look either incompetent at credit analysis or like we sold our soul to the devil for revenue, or a little bit of both.” Another former ratings agency employee stated that senior managers “intimidated” analysts and wanted employees who were “docile” and “afraid to upset the investment banks.”79 Rating analysts often achieved higher bonus compensation based upon the performance of the ratings firm. Even as late as 2008, the SEC found that ratings analysts at rating agencies seek to maintain their firms’ market share and are actively involved in fee negotiations. Thus, the SEC concluded that firms failed to mitigate the inherent conflicts in the issuer-pays model for rating agencies.80 Investors face uphill struggles to hold the ratings agencies accountable. In fact, some courts rule that the ratings agencies may not be held liable under the First Amendment of the U.S. Constitution in the absence of actual malice.81 Under the PSLRA, only claimants who can show a strong inference of intent to defraud before any discovery may prevail.82 Professor Frank Partnoy sums up the legal landscape regarding efforts to hold the ratings agencies accountable: “The only common element  .  .  . is that the ratings agencies win.”83 Consequently, the economic incentives for the rating agencies amounted to seeking revenue by diluting any due diligence regarding the risks of a given subprime deal. Efforts to regulate the ratings agencies generally met with resistance not just from the agencies themselves but from their clients that paid for their services—the investment banking and securities industry. A 2006 effort to enhance regulatory power over the ratings agencies failed in Congress. Senator Charles Schumer of New York led this effort. Schumer raised millions (more than any other senator save one) from the very Wall Street firms that benefited so much from their cozy relationship with the ratings agencies.84 As a result of these efforts, the Credit Rating Agency Reform Act of 2006

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Too-big-to-fail means massive market distortions and excessive risk at the very heart of the economy. Thus, the too-big-to-fail firms will gorge on risk in an otherwise inexplicably inept way—particularly if such risks lead to short-term profits and thereby enhance compensation. Soon competitors seek too-big-to-fail status and the market distortions spread. 90 Once implicit government subsidies take hold, reckless derivatives trading and dangerous investments in subprime mortgages become more tempting. Ultimately, management enjoyed complete insulation from risk. The government committed hundreds of billions of dollars to save megabanks like Citigroup from failure. The winners achieved unbargained-for government guarantees of their claims against Citigroup—including compensation claims held by Citigroup managers. CEO Charles Prince gained at least $50 million in additional compensation after the government bailout.91 In FDIC liquidation, such claims would normally be paid only pennies on the dollar, at best. The government similarly allowed management to continue in power. This created pressure for management to conceal losses and hoard capital in the hope that they could continue to run the bank in its “zombie” (not quite dead, but on government life support) form. New managers, on the other hand, always have incentives to recognize all losses immediately so that legacy problems do not reduce future earnings; in fact, when excessive losses are recognized immediately, future income is enhanced. New managers are also unlikely to hoard capital and instead would make loans to generate profits.92 Government guarantees for speculative activities (such as investing in high-risk subprime loans and related derivatives) will create too much risk in an economy. Too-big-to-fail policies create grotesque incentives, particularly if top management is incentivized to achieve high profits. Government guarantees encourage anything that creates profits today at the expense of risk tomorrow. Indeed, the government will even bail out the executives who saddled their firms with too much risk if they hold political sway. Executives seek too-big-to-fail status because they can then seek maximum profits regardless of risk and then rely upon government to socialize the risk. Managers emerge unscathed financially after the collapse of 2008.93 This exacerbates the problems in corporate governance law, highlighted in the previous chapter. Too-big-to-fail policies combined with lax regulation of derivatives and other risky investment instruments create a particularly dangerous outcome. If capitalists do not know the precise contours of derivatives risks, then in an uncertain market environment capital will flee all firms suspected of derivatives exposure and a credit crunch will ensue. Without basic financial transparency,

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Economists and financial scientists study economies of scale in the financial sector. Their findings suggest that financial performance of large banks peaks at about the size of $10 billion in assets.96 Nevertheless, the law permits and even facilitates vastly larger financial conglomerates. In 1999, for example, the Financial Services Modernization Act97 repealed the Glass-Steagall Act.98 Glass-Steagall limited the size of financial institutions by prohibiting the combination of commercial banks and investment banks. This effectively limited the concentration of economic power, and as Joseph Stiglitz highlights, New Deal regulations like Glass-Steagall ushered in a remarkable era of rapid economic growth, financial stability, and enhanced economic equality.99 Strong financial regulations did not stifle economic growth; they secured it. Critics of the repeal of Glass-Steagall specifically warned that its elimination would lead to financial catastrophe and huge government bailouts of the financial sector, and their predictions proved accurate.100 In fact, one of the most notorious banks at the eye of the financial maelstrom, Citigroup, specifically needed the Financial Services Modernization Act to give legal legitimacy to its previously unlawful merger with Travelers in 1998. “Armed with boatloads of cash,” Citigroup undertook a lavish lobbying effort to secure the repeal of Glass-Steagall. Yet the promised benefits of consolidation and so-called financial supermarkets never materialized. Instead Citigroup became too-big-to-manage as serial setbacks infected each of its many operating divisions. One commentator notes that the market value of Citigroup fell from $274 billion to $16 billion in the decade after its union with Travelers. Economically, allowing these megabanks to emerge proved an “utter disaster,” and even Citigroup’s former CEO and chairman state that they regret the repeal of Glass-Steagall and that the bank is now “too big to manage.”101 After the repeal of Glass-Steagall, a key barrier to financial concentration fell. Regulators—with the Fed leading the charge—long facilitated massive financial sector consolidation even prior to the formal repeal of Glass-Steagall.102 Early on, critics predicted that this consolidation would lead exactly to the financial crisis we just experienced.103 This legal indulgence of consolidation run amok mirrored a generally docile approach to competition law policy and consolidation of firms generally, which included unregulated financial firms such as mortgage originators.104 According to Robert Scheer, the repeal of Glass-Steagall resulted from the most massive lobbying effort in congressional history, amounting to $300 million. Treasury Secretary Rubin strongly supported the repeal, and he made $33 million at Citigroup the year after he left the Clinton administration.105 The fingerprints of concentrated

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Senator Schumer also advocated that the banking regulators loosen capital requirements for large banks. Even as late as June 2007, when subprime risks became manifest, he wrote to the Chair of the FDIC that “I do not agree that more capital is always better.” Schumer wished the bank regulators to hasten their implementation of the Basel II capital regulation regimen.109 Basel II essentially outsourced the capital regulation to the banks themselves and to the credit rating agencies. More specifically, highly rated (according to the models of the co-opted rating agencies, no less) debt paper counted as capital. And, the banks’ own risk models form the basis of the Basel II regimen. Thus, Basel II outsourced capital regulation to private risk models as never before.110 Even before Basel II, derivatives empowered many banks, such as Citigroup, to evade regulatory mandates through off–balance sheet entities. Ultimately, Citigroup obliged itself to repurchase derivatives in the form of special purpose entities based upon liquidity puts that allowed purchasers to put the interests back to Citigroup in the event of financial turmoil. Citigroup’s financial statements did not reflect this obligation, which proved quite costly to Citigroup. When the subprime losses emerged, America’s largest financial institutions failed to weather the storm because they operated with too much debt on their balance sheets and not enough equity. The leverage contributed to firm profits while the party lasted, but when the inevitable hangover took hold, American banks toppled in unison. The Shadow Banking System The global shadow banking system also contributed to global financial instability when the crisis hit. The shadow banking system consists of a variety of institutions that facilitate lending but do not take retail deposits and therefore are not subject to traditional bank regulation. The institutions include investment banks, private equity funds, hedge funds, special investment vehicles, and asset conduits. Professor Gary Gorton zeroes in on the shadow banking system and its lack of regulation as a key cause of the subprime crisis of 2007–9. He argues that the shadow banking system operated as a key cog in the lending process by investing in a variety of securitizations and collateralized debt obligation funds. Basically, these are pools of debt instruments such as credit card receivables or mortgages. The shadow banking system became a key source of funding for traditional bank loans. Banks bundled up loans and sold them to the shadow banks rather than hold traditional loans in their portfolios.111 Immediately prior to the crisis, the shadow banking system rivaled the traditional banks in terms of actual loan funding.112

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A lender of last resort addresses the fact that banks lend over the long term and borrow short term. If financial markets fall into a panic, then liquidity could dry up to such an extent that even strong banks cannot roll over their liabilities or meet depositor demands for cash and thereby fail. A bank may face a liquidity crisis even though it holds plenty of solid collateral. The Fed long used its discount window to lend to solvent banks based upon adequate collateral.118 The financial crisis of 2007–9 saw the lender of last resort power of the Fed explode into a wholly new function without any legal charter to do so— propping up the entire global financial system. The Fed deserves some degree of credit for its vigorous action in the face of a historic financial collapse. Moreover, a bailout agency with an appropriate institutional design could well enjoy a sound economic rationale. Nevertheless, a central bank’s use of its prodigious monetary policy powers to save politically powerful market participants from economic pain and accountability cannot be justified, and the Fed flirts with precisely this outcome. I take up the issue of bailouts in chapter 6. Here, I merely wish to spotlight the behavior of the Fed to serve political expediency rather than employ sound lender of last resort policies in the recent financial crisis. The Fed bailouts commenced in early 2008 with a bailout of Bear Stearns. Bear borrowed heavily to fund investments in toxic loans and undertook further exposure in derivatives. Bear’s failure consequently posed massive systemic risk. Creditors lost confidence in the ability of Bear to avoid insolvency, and an electronic bank run occurred on the investment bank. Fed Chair Ben Bernanke concluded that Bear could not be permitted to enter bankruptcy, or financial chaos would ensue. The Fed acted through JP Morgan Chase to arrange a subsidized merger between Chase and Bear.119 The Fed used emergency powers to guarantee $30 billion of toxic Bear assets. The Fed’s action left it in uncharted waters. It had never before used its lender of last resort powers to rescue a nonbank from insolvency.120 The Fed also undertook a series of extraordinary actions designed to keep the financial sector afloat. It committed to purchase $1.5 trillion in mortgagebacked securities, singlehandedly keeping the residential mortgage market functioning. It also purchased $500 billion in Treasury Securities. The additional demand generated through the Fed purchases increased the value of these securities; that, in turn, boosted the trading profits and balance sheets of every bank as banks hold trillions in aggregate in government securities and mortgage-backed securities. The Fed also now lends money to member banks at zero interest and at the same time pays interest on the excess reserves the banks hold. It is impossible to know the final cost of all of these

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on AIG. The Fed again invoked its emergency powers to lend AIG $85 billion and took an 80 percent ownership stake in the world’s largest insurance company. Later the Fed advanced billions more. The largest beneficiaries of the AIG bailouts were the counterparties to the billions and billions of risks it had underwritten through credit default swaps. Goldman Sachs (Paulson’s former firm) raked in $13 billion, more than any other American financial institution. In all, the Fed ultimately extended a $185 billion line of credit to AIG.125 The government left the market and market experts befuddled as a result of its ad hoc bailout policy.126 These actions signify the most highprofile and expensive bailouts amidst a flurry of bailout activity prior to the passage of the TARP program (discussed in chapter 6).127 All of these bailouts make a mockery of a sound and disciplined lender of last resort function for aid to otherwise solvent banks, and our democracy itself, as the Fed and others exceeded their traditional statutory charters.128 Taxpayers not only paid for the bailouts but also suffered through a capital-starved economy. Predictably, all of these programs failed to re-ignite lending or to revive the economy. Instead, the banks hoarded capital. Essentially, the rationale for the big bailouts can be found not in economics but in political power. As Joseph Stiglitz states, the “big banks used their political influence to get deregulation; they used their political influence to stop initiatives for new regulations to restrict their excessive risk taking in derivatives; and not surprisingly, they then used their political influence to get this massive unwarranted transfer of money from the American taxpayers.”129 The bailouts proved costly, ineffective, and deeply suboptimal precisely because the bailouts appeared politically driven. As former President of the Federal Reserve Bank of St. Louis William Poole puts it: Our current bailout world is an affront to democracy.  .  .  .We know that many executives of financial firms, despite huge losses, have larger fortunes remaining than most of us can ever dream of enjoying. Taxpayers, in general, will pay for losses incurred by the insolvent, or nearly insolvent, firms these executives left behind. These bitter attitudes in our society today tend to be dismissed as “populist.” That is a mischaracterization; no one, whatever his political persuasion, should be willing to accept without complaint wealth transfers of the sort now taking place.130

These bailouts posing as lender of last resort loans to otherwise solvent banks so far exceed the authority of government officials as to constitute lawlessness.131 This entire regulatory morass in the financial sector created the essential conditions for a “bursting asset bubble nourished on high leverage,” which

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federal agency. In 1935, Congress stated that this independence would permit the Fed to vindicate the “general public interest” and not indulge “the majority of special interests.” Since 1935, Congress and the executive, with the insistence of financial markets, remain committed to Fed independence over monetary policy. Today the Fed enjoys self-funding, high staff salaries, long tenure for Governors, and post-employment job restrictions.136 This institutional design permits the Fed to set monetary policy free of special interest influence.137 Yet the power the Fed holds as monetary authority and lender of last resort may well be enough power in one agency. The Fed’s performance as bank regulator in the subprime crisis rates poorly. At the least, the Fed should be restructured to eliminate the influence of the privately held regional banks. Private bank interests participate in making monetary policy through the Federal Open Market Committee, which includes regional Federal Reserve Bank Presidents. This committee influences short-term interest rates through the purchase and sale of government bonds. The Federal Reserve member banks (pure private banks) elect regional bank directors and ultimately presidents. The proximity of the Fed Governors to the banking interest appeared tolerable until recently.138 Today, the proximity of the banking industry creates the appearance of corruption.139 The recent financial crisis proves that the Fed struggles to be an effective regulator. The nonregulation of subprime mortgages alone justifies a restructuring. The Fed also played key roles in facilitating the massive consolidation of the financial sector, undercutting the regulation of derivatives, and allowing its lender of last resort function to become a politicized bailout facility. Two means of improving the Fed’s structure would entail (1) eliminating the influence of the private banks through the abolition of the regional banks and (2) limiting the Fed’s function to that of a pure monetary policy agency, to the extent practicable.140 The Dodd-Frank Act originally moved in this direction but failed to change the institutional structure of the Fed in a meaningful way.141 The Fed holds too much power to act as both monetary authority and regulator. Fed Chair Alan Greenspan’s faith in markets seemingly rendered him ideologically blind to the possibility that asset bubbles could develop in response to lax monetary policy, and this blindness no doubt contributed to the subprime debacle. In addition, Greenspan ardently pursued deregulation that again seemed ideologically driven and certainly contributed to the ongoing financial crisis.142 These blind spots support an argument for limiting the regulatory power of the monetary authority. Bank regulation and monetary policy simply cannot rest upon the ideology of a single person.

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so that banks might show more capital on their financial statements than under preexisting mark-to-market accounting.148 “A few choice words from politicians was all it took for the fearless members of the accounting watchdog to turn from staunch defenders of ‘fair value’ [accounting] to advocates of the more ‘flexible’ approach so beloved by banks.”149 The SEC actively opposed efforts to regulate derivatives and supported its own rule requiring disclosure of derivatives risks with half-hearted enforcement efforts that Professor Fisch terms “a strikingly light touch.”150 The SEC’s legal structure must impose additional protection from political pressure exerted by those with economic power. The bank regulators could also benefit from enhanced political independence. Regulatory competition poses a major threat to sound regulation, if regulatory competition does not benefit from appropriate legal infrastructure. Bank regulation creates direct competition for client banks to charter under either state or federal regulatory regimens. Indeed, as previously mentioned, the largest subprime originator, Countrywide Financial, switched charters specifically in search of more permissive regulation for its subprime activities. None of the federal regulatory agencies did much to discipline subprime lenders or securitizers. In addition, by permitting ever more complex trading in over-the-counter derivatives, the banking regulators basically suspended capital rules and permitted even more leverage in the financial sector because such derivatives get priced to models, not to markets. This throws open the door for manipulation of minimum capital levels.151 Former Treasury Secretary Lawrence Summers, who had a front-row seat during the Clinton administration’s forays into financial deregulation, bemoans the lack of space between those regulators that big finance co-opts and regulators ignorant of finance’s complexities. According to Summers, “We have a broad social problem that covers everything from finance to deep sea drilling and nuclear power . . . there is hardly anybody who is both knowledgeable and not co-opted.”152 The legal design of regulatory institutions can create a class of expert regulators that can resist ultimately serving the needs of the regulated. High salaries, secure tenure, and post-employment job restrictions logically operate to shut down the revolving door between the regulated and the regulators and to secure sophisticated regulation. Expanding Federal Professionalization The toxic assets of the Great Depression consisted of shares in corporations rather than subprime mortgages. During the boom of the 1920s, fully onehalf of the total securities issued by corporate America turned out to be

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over the ratings agencies. The agency would enjoy independent funding in the form of user fees and operate subject to SEC oversight. Board members of the CRAOB would possess expertise in financial markets. Post-employment job restrictions would shut down the possibility of a revolving door between the regulatory agency and the rating agency. It would impose broad disclosure requirements upon the rating agencies, even with respect to methodologies. Partnoy’s proposal would specifically entail congressional action to resolve the conflicts implicit in the issuer-pays model of rating; for example, the rating agencies (similar to accountants regulated under the PCAOB) could be barred from receiving any other compensation from issuers.159 Partnoy strengthens his regulatory approach through a backstop of civil liability for rating agency misconduct. Liability and Private Enforcement of Accountability Partnoy posits that because the ratings agencies enjoy de facto immunity from liability, they behaved as expected: engaging in more negligent, reckless, or fraudulent behavior than if they faced real threat of liability. He suggests that the rating agencies exploit this immunity from liability to enhance their operating profits (for example, skimping on staff) and pay larger compensation to their senior officers. Thus, he argues that Congress should roll back the ratings agencies’ immunity and impose accountability for flawed ratings on par with that of accountants and lawyers.160 The expansion of civil liability standards to incentivize financial sector professionalism draws support from the success of the New Deal. The final element of the New Deal approach to pulling the financial sector out of its laissez-faire abyss involved broadening concepts of fiduciary obligation, particularly with respect to disclosure obligations. As President Franklin Roosevelt himself stated in his message to Congress accompanying the Securities Act of 1933, “This proposal adds to the ancient rule caveat emptor, the further doctrine ‘let the seller also beware.’ It puts the burden of telling the whole truth on the seller.”161 Efficient markets require perfect information. So, the idea of legally requiring truth in the sale of securities supports financial market functioning. As previously mentioned, the federal securities laws enjoy solid empirical support for their operation as the epitome of legal infrastructure. The subversion of private actions under the federal securities laws broke down traditional disincentives facing securities fraudfeasors. For the first time ever in our history, the federal securities laws operated to shield fraudfeasors from liability for fraud after the PSLRA and the SLUSA.

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as finally passed authorized 243 rulemakings and 67 studies. Financial and public firms appear willing to spare no expense to influence these administrative proceedings and dramatically increased lobbying activity at both the SEC and the CFTC.165 Against this barrage, sound policy stands little chance. The Act itself holds some hope. For example, the law outlaws predatory home loans and extends borrowers potentially powerful remedies for violations of this prohibition.166 It also creates a Consumer Financial Protection Bureau charged with protecting consumers from abusive credit transactions.167 Congress also saw fit to subject the credit rating agencies to liability under the federal securities laws to the same extent as lawyers and accountants.168 Perhaps most important, the Act gives regulators the power to break up large banks, albeit under narrow circumstances that requires action of the Fed (and a two-thirds vote of the Financial Stability Oversight Council, which includes the Secretary of the Treasury as Chair), which can be tightly aligned to the financial sector.169 On the other hand, the Act calls for a “study” of the PSLRA but no rollback of its provisions that operate to insulate securities fraudfeasors from liability.170 The Act also mandates a study of the issuer-pays model of ratings agency compensation in 2012 but leaves that model intact while imposing only uncertain liability.171 The Act separates certain high-risk trading and hedge fund activity from commercial banks, but complete divestment may be delayed until 2022.172 The restrictions regarding derivatives trading by banks include exemptions that may well prove to swallow the rule and do not take effect until July 2014 at the earliest.173 The Act largely preserves the ability of the Fed to expand its lender of last resort function into a broad-based bailout regimen.174 Perhaps most notably, the Act fails to restructure any administrative agency, fails to repeal the PSLRA and the SLUSA, fails to create any new professionalization regimen for any element of the financial sector, and fails to mandate the breakup of any large financial institution. A final assessment of the Act depends upon the actions and rulemaking of numerous administrative agencies. The efforts of the financial industry to weaken the Act over time could greatly undermine its promise. As memories of the cataclysm of 2008 fade, the public is not likely to remain engaged. Time is on the side of the financial sector. Indeed, the 2010 election swept into the House of Representatives a Republican majority that ran on an antiregulation platform.175 Thus, Dodd-Frank seems destined to fail to curb the power of Wall Street and prevent another market collapse. Attacks on regulatory infrastructure caused the subprime fiasco, and that is evidenced by the erosion of basic and sound regulatory principles. Much of

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preservation of domestic agriculture subsidies to patent protection for lifesaving drugs—reflects this power.18 First, the U.S. controls key institutional elements of the global economy, including the International Monetary Fund (IMF), the World Bank, and the World Trade Organization (WTO). Second, the political context within the U.S. is such that globalization issues are determined by transnational corporations and particularly their CEOs. The Department of the Treasury acts on behalf of financial firms; the Department of Commerce acts on behalf of industrial firms.19 Therefore, given CEO primacy over the corporation, globalization has been structured to serve the interests of CEOs of transnational corporations.20 Those interests revolve around short-term profits with little or no regard for long-term stability and growth. With respect to the World Bank and the IMF, the U.S. exercises informal power to select the head of the World Bank and essentially exercises veto power over the IMF. Only the U.S. holds this kind of effective veto over the IMF.21 These powers rest primarily with the Department of the Treasury. “The IMF and the World Bank were part of Treasury’s turf, an arena [in] which . . . they were allowed to push their perspectives, just as other departments, within their domains, could push theirs.”22 The Department of the Treasury, in turn, tends to the interests of Wall Street firms.23 Moreover, the U.S. also has a high degree of leverage over both the World Bank and the IMF as a result of its funding practices with regard to both of those agencies. Each time the IMF or World Bank requests funds, Congress uses the opportunity to threaten to withhold funds. Thus, the international financial institutions must placate not just the current administration but also Congress.24 The U.S. also possesses a high degree of informal power as the largest shareholder of the international financial institutions. The staffs understand that it is a waste of time to present any important recommendation without first clearing it with the U.S.25 “In sum, the US has substantial capabilities to bring to bear in shaping the mandates, policies and modus operandi of [the] international financial institutions.”26 Thus, when the U.S. Treasury pushed for financial market liberalization, the IMF and World Bank pushed for financial market liberalization.27 Deregulation, reduction of trade barriers, and an austere vision of government action came to define this version of globalization under the stewardship of the Washington Consensus.28 The U.S. thus determines the core aspects of policy and structure within both the IMF and the World Bank. With respect to the WTO, the U.S. enjoys disproportionate bargaining power in negotiations as a result of the size of its consumer market.29 The former chief economist of the World Bank Joseph Stiglitz suggests that “in

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(except for the freedom of people to move in response to higher wages). Finally, this extreme adherence to market fundamentalism means that trade barriers for goods and capital should always be eliminated immediately, and capital markets should be fully deregulated. The subprime mortgage debacle demonstrates the dangers of allowing this model of globalization to persist. In short, laissez-faire globalization conveniently generated massive profits for corporate and financial elites even while fomenting financial crises and economic disruptions. Trade Imbalances, Job Losses, and Debt Immediately prior to the financial crisis of 2007–9, the U.S. trade deficit stood at $788 billion. This means the U.S. consumed more than $2 billion more in foreign goods per day than it produced in exports. Financing the difference between exports and imports meant the U.S. rang up a current deficit of roughly the same amount and foreigners acquired that amount in claims—mainly debt claims—against the U.S. economy. Essentially the U.S. borrowed $2 billion a day to finance excessive consumption on the backs of mostly poorer developing nations. Even those taking an initially sanguine view of these imbalances ultimately concluded that the constant demand for and accumulation of U.S. debt instruments in connection with the trade deficit led to lower interest rates in the U.S. that “facilitated a boom in residential [real estate] and mortgage lending.”42 Others state that “epitomized by the China–U.S. bilateral trade relationship, these imbalances played at the very least an important supporting role in bringing on the financial crisis.”43 Nouriel Roubini and Stephen Mihm argue that these trade imbalances inherently destabilize the global economy and will lead to serial crises if not remedied.44 Former Treasury Secretary Henry Paulson lists the trade imbalances as the first of four “crucial” issues driving the subprime crisis.45 The U.S. trade and current account imbalances metastasized from deep roots. After the historic East Asian currency crisis of the late 1990s, developing nations around the globe cut back on investment and consumption in order to save more and build foreign reserves, so that their currencies would stabilize.46 Holding reserves in an easily converted currency like the dollar means that a nation could sell reserves in a crisis to constrict the global supply of its own currency and thereby protect its value. Holding reserves therefore provides ammunition to protect currency value, and to deter speculative attacks upon a currency. By 2006, China alone held nearly $1 trillion in dollar reserves and other East Asian countries held another $1.3 trillion—and most of these reserves are held in the form of (perceived) safe debt instruments.

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total estimated reserves approached $7.5 trillion.58 Necessarily, these reserves mean an increase in debt across the globe—every creditor needs a debtor.59 This excessive debt effectively buried durable buying power. The U.S. acted as the consumer of last resort accumulating vast debt to furnish unsustainable demand to the global economy. While the U.S. bore the brunt of these capital flows, the euro served as the secondary reserve currency. The accumulation of euros also led to a concomitant loss of competitiveness and excessive debt in the eurozone. According to the European Central Bank, as of the end of 2010, euro-denominated assets constituted 26.3 percent of all reserves.60 The huge cash flows from the developing world fueled debt accumulation in Greece, Spain, Ireland, Portugal, and the entire European Union. Once the crisis of 2007–9 crippled the global economy, these nations buckled under their own excessive debt loads.61 The debt crisis inevitably moved from U.S. shores to engulf the eurozone. Over a period of twenty years the U.S. went from the largest creditor nation to the largest debtor nation. External debt nearly doubled to 40 percent of GDP by 2008. This is on par with Argentina’s debt levels prior to its financial meltdown in 2001.62 Declining wages and job prospects within the U.S. rendered that level of debt unsustainable. Even prior to the subprime implosion, economists warned that “the current system is fraying at the edges.” The essential problem arising from this dollar reserve system is that “the reserve currency country winds up getting increasingly into debt, which eventually makes its currency ill suited for reserves.”63 Moreover, there is “something unseemly about the poorest countries providing low interest loans to the richest.”64 With more than 2 billion souls subsisting on less than two dollars per day, it is simply impossible to justify $788 billion per year flowing to the U.S. to finance predatory lending of the disempowered there. Legal frameworks must operate to disrupt this economically and morally bankrupt reality. Essentially the entire global economy leveraged growth upon the cheap labor of the developing world and the ever-increasing indebtedness of the developed world. A debt crisis seemed all but certain from this perspective. All this cheap debt triggered a global housing market bubble. In fact, Joseph Stiglitz, Nouriel Roubini, Robert Shiller, and other economists predicted a crisis arising from the bursting of the bubble and the excessive debt generated by globalization.65 Throughout 2005–7, many experts raised alarms that the global economy faced a meltdown.66 Former Fed Chair Paul Volcker projected a 75 percent probability of a financial crisis, and the chief economist of Morgan Stanley predicted financial “Armageddon.”67 The Economist warned in mid-2005 that a painful global housing crash appeared imminent and one year later that a global debt crisis loomed.68

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Figure 4.1 Corporate profits/GDP (Source: Federal Reserve Bank of St. Louis)

performance and the ever-present protection of golden parachute arrangements approved by board cronies. The easy money explains the structure of globalization—cheap wages and consumption on steroids fueled by excessive debt. As I stated in 2007, “CEOs have the motive and the means to increase their compensation notwithstanding the deleterious long term financial consequences.”71 The accompanying graph shows the enhanced profitability of corporations relative to GDP over the past twenty years of globalization on the cusp of the crisis. Today, globalization furnishes yet another means by which corporate and financial elites use their political power to impose massive costs worldwide in order to boost their short-term compensation payouts (based upon higher profits). Fundamentally, globalization as presently constructed means lower wages. The law governing globalization permits greatly enhanced mobility for jobs. Thus, more lost buying power seems inevitable. The nations receiving jobs cannot replace that lost buying power. By definition, the jobs move to low-cost locales. Further, these nations must save massive funds in order to continue to accumulate dollar reserves. China, for example, spends about one-half of what the U.S. spends on consumption relative to GDP.72 As previously noted, many nations other than China accumulate dollar reserves,

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a result of greater demand for all goods and services, and therefore durable buying power.81 One important reform would entail empowering labor to move to its highest and best use, just as capital or jobs may move to more profitable locales. Free market capitalism supports the creation of a trade regimen that sought to vindicate gradually the right of people to move to their highest and best use. Capitalist theory long emphasized that all resources must be perfectly mobile in order for markets to allocate wealth efficiently.82 Given the centrality of human capital to innovation-led growth, impediments to the free movement of labor entail great costs. Decades ago, economists estimated that global output could double under a free movement of labor approach.83 More recently, economists put the cost of barriers to labor mobility at $55 trillion.84 The benefits of free labor mobility include enhanced cultural diversity, which can operate to enhance cognitive functioning and support enhanced innovation.85 Moreover, because of the value of labor complementarity, high-wage labor may increase its productivity when low-wage labor becomes more available.86 Finally, enhanced market development associated with developed nations means that human capital is more productive

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to human capital rather than the accumulation of human capital; therefore, free movement of labor can generate out-sized gains through remediation of inefficient human capital distribution. Free movement of labor holds the promise of massive economic gains relative even to enhanced human capital investment.97 Immigration also spurs innovation through enhanced cultural diversity. In a recent study, economists found that in the U.S., immigrants patent at double the native rate. Moreover, based upon state data, immigrants spur patents sought by natives. States with higher levels of immigrants saw native patents jump by 15 percent.98 This finding is consistent with studies finding that urban areas with a larger share of immigrants achieved higher growth. Thus, immigration operates not just to exploit well-developed markets but to contribute to well-developed markets through enhanced workforce cognition and innovation.99 In the end, durable consumption rests upon enhanced worker productivity. The global economy of the 2000s needed more balanced consumption and production. Allowing the free movement of labor offers one possible solution to the huge imbalances that marred the global economy in the years prior to the debt crisis. Developed nations learned from experience that capitalism can achieve high levels of macroeconomic growth only if regulatory infrastructure guides free markets and secures a robust middle class. Yet, corporate elites set globalization on a path toward a perverse form of laissez-faire that fundamentally empowered capital over people. This proved corrosive to a robust middle class and created a chronic crisis of buying power as elites chose short-term profits over sustainable globalization, a pattern further evidenced by the fate of economic human rights. Securing the right of labor to move freely in accordance with capitalist theory will add trillions in new wealth to the global economy. Other economic human rights can further secure a more robust global economy. Global Market Development under Law As demonstrated in chapter 2, the division of labor (or the specialization of labor) and the extent of effective buying power constitute the key drivers of growth. This suggests that globalization can charge transnational economic growth by extending markets. Instead of market development, corporate elites exploited the most well-developed consumer market in the world—the U.S. consumer market. The U.S. acted as the consumer of last resort worldwide, but globalization subverted the American consumer through the offshoring of jobs and cheap debt. In a classic tragedy of the commons episode,

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“Researchers have found repeatedly that education plays a major role in economic growth.”106 Basic education is fundamental to economic performance; thus, raising literacy rates is a powerful means of achieving greater economic growth. “A country that achieves literacy scores one percent higher than average ends up . . . with labor productivity and GDP per capita respectively higher by 2.5 and 1.5 percent on average.”107 Higher education is crucial for innovation and is therefore a key driver of growth in developed and developing countries.108 Indeed, expanding wage premiums for college graduates since World War II suggest that demand for educated workers outstrips supply. Yet, the transition to a knowledge-based economy that relies upon innovation to drive technological change requires more highly educated workers.109 A laissez-faire approach to education will fail to ensure that appropriate educational investments are made because of imperfect credit markets that allocate funds to those with collateral instead of to those with talent as well as the fact that education spurs positive spillovers that diminish individual incentives for investment. More specifically, because the poor have inadequate collateral they are credit-constrained and unable to develop their human capital; under such conditions, government could enhance growth and incentives by giving all children access to excellent educational opportunities.110 As the World Bank notes, imperfect credit markets mean that highly capable poor children will not get basic education while wealthy children who are less able may go to college.111 This “tyranny of collateral” invariably translates into a massive loss of economic opportunity and diminished growth.112 These credit constraints compromise innovation-led growth and, ultimately, durable consumption. Politically, education will get short shrift because of the extended period necessary for the full benefits of such investments to come to fruition.113 Indeed, even public funding of education is subject to imperfections, as politically powerful elites will work to divert public funds from broad-based education.114 One study found that funding on education is biased toward the rich and that “weak governance leads to intensified rent-seeking over public education funds, increasing inequality, reducing social mobility, and slowing growth.”115 As could be expected, in an environment with high political inequality, elites will diminish public education funding.116 Thus, funding for education suffers financing infirmities. Additionally, given the huge economic payoffs of appropriate education, facilitating deeper and broader education investments will lead to enhanced economic growth. As demonstrated previously, in chapter 1, skills development (rather than mere years of schooling) is powerfully associated with

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of gains from such investments suggests that societies are under-investing in social safety nets. Moreover, weak social safety nets may also be associated with financial crises and disruptions. Professor Raghuram Rajan makes exactly this argument in his recent book Fault Lines. Rajan argues that in the U.S. political elites found it expedient to support consumption through wider access to credit rather than to invest in education, which has extended payoff periods—payoff periods that would include a time when such elites were no longer in office. Thus, in the face of declining wages, high inequality, and more difficult employment prospects, the U.S. gorged on debt. This high level of debt destabilized the economy and ultimately triggered a historic credit crunch. Rajan specifically argues that stronger safety nets would have relieved political pressure to maintain living standards through enhanced debt.125 The Universal Declaration also states that “everyone” is entitled to be free from discrimination, presumably based upon race, gender, caste, religion, class, or similar constructs.126 Economists have long recognized that because these constructs have nothing to do with merit and operate to strip people of the opportunity to be as productive as their talents permit, discrimination based upon such elements reduces the output of a nation’s labor force.127 The World Bank documents the underlying dynamics of how artificial constructs destroy human capital.128 In a recent study, the Bank found that lower-caste children in India taking cognitive tests scored lower than high-caste children when caste was announced but scored at parity when caste was concealed.129 This study replicates the work of Professor Claude Steele in demonstrating the pernicious effects of “stereotype threat” on the performance of African Americans in the U.S.—as well as studies from around the world demonstrating compromised performance by oppressed minorities worldwide.130 All of these human rights ultimately prove conducive, even essential, to growth.131 Unfortunately, human rights (including economic human rights) are enforced through moral suasion and embarrassing publicity rather than through more meaningful legal sanctions. Currently, economic human rights are enforced pursuant to annual reporting obligations to the Committee on Economic, Social, and Cultural Rights. This committee is charged with monitoring states’ compliance with economic human rights and has the power to make recommendations for compliance. These recommendations do not have the force of law.132 No transnational authority can mandate that any sovereign nation make any expenditure to support human rights.133 Nor will such an authority emerge anytime soon. States value sovereignty too much to create such a broad and arguably intrusive array of enforceable economic

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With global currency reserves now totaling more than $10 trillion, the world holds the resources to fund economic development on a grand scale that would dwarf the Marshall Plan or the GI Bill.141 These resources currently subsidize excess consumption fueled by excess debt within the developed world—especially the U.S. and Europe—and operate to expose the global economy to serial financial crises. The global community could redeploy these resources to help finance a more sound global economy. If there were a global bank in which nations deposited their reserves safely (such as with the IMF) while such funds were productively invested in economic development (under the development expertise of the World Bank), then these massive reserves could support growth rather than unsustainable debt-driven consumption in the developed economies. In other words, these resources could be banked, and therefore leveraged, to fund the most promising human capital and infrastructure investments within the developing world.142 This could, in turn, create a durable foundation for more expansive and stable global consumption. Economists since John Maynard Keynes in 1944 have argued in favor of precisely this kind of support for durable global growth. Moreover, the IMF would need only extend modestly its current operations as global lender of last resort to provider of a global reserve currency.143 The details admittedly involve a level of complexity beyond the scope of this book; nevertheless, the world clearly holds sufficient wealth to fund massive economic development perhaps exceeding $100 trillion (because of fractional reserve banking).144 A gradual shift to such a regimen could stimulate immediate growth for decades. The IMF currently pursues its mission of macroeconomic growth and stability through two primary channels. First, the IMF as international lender of last resort provides liquidity to nations to meet external financial obligations.145 When the IMF bails out a nation, it imposes conditions—and thus far those conditions have generally mandated a market fundamentalism approach.146 Second, the IMF undertakes annual “consultations” regarding the economic and financial condition of nations.147 The outcome and nature of these “consultations” are crucial to the ability of most nations to raise external capital.148 There is no reason why securing economic human rights cannot become central to both of these functions, pursuant to a clear and transparent policy, rather than its current approach, which too often seems driven by the needs of the developed world.149 With respect to conditionality, the IMF should mandate that additional resources be devoted to economic human rights in appropriate contexts. This new emphasis on economic human rights would be in accord with the IMF’s most fundamental mission of fostering global growth.

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invest a portion of such gains in the economic human rights of their citizens in the cause of global growth hardly seems unreasonable. Arguably, people should possess the right to move freely in response to economic incentives as a human right. Regardless, the WTO should break down trade barriers applicable to the free movement of labor with the same zeal it applies to all other trade barriers. Given the gains to both the developed and the developing world, the WTO should pressure all nations to lift trade barriers on labor as a means of reviving the languishing Doha round of trade talks that initially focused on development issues. “The gains to poor people from relaxing the existing barriers to labor mobility are enormous relative to everything else on the development table.”160 Despite the not insignificant social costs of labor migration (loss of social cohesion, scapegoating, etc.), the economic benefits from labor liberalization suggest that an international accord to support free movement of people could spur rapid economic development.161 In September 2005, the World Bank released a report entitled Equity and Development.162 The gist of the report is that market fundamentalism permits human potential to languish on the margins of the global economy. “The plea for a more level playing field in both politics and the economies of developing countries serves to integrate the World Bank’s twin pillars of building an institutional climate conducive to investment and empowering the poor. . . . Greater equity can, over the long run, underpin faster growth.”163 Indeed, empirically laissez-faire too often leads to entrenched elites who will impose economic conditions that are hostile to maximum output and growth, rather than an optimized system of incentives and disincentives.164 The World Bank report dramatizes the economically pernicious destruction of human capital that follows deep inequality and demonstrates the need to strip elites of the power to destroy human potential. The report opens by introducing two young children born on the same day in 2000—Nthabiseng, born in Eastern Cape, South Africa; and Pieter, born in Cape Town. One is a black girl and the other is a white boy. After surveying their life circumstances, the Bank concludes that “the opportunities these two children face to reach their full human potential are vastly different from the outset, through no fault of their own.” Further, the destruction of opportunities available to Nthabiseng will have societywide impact, as any brilliance or innovation she could have achieved is likely to go to waste.165 In short, the World Bank challenges the law to secure human capital investments, at least to the extent that social payoffs exceed social costs, despite the harmful influence of growth-retarding elites.166 This is now mainstream economic science, as empirical studies increasingly demonstrate the harm inequality inflicts

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economic power, or cultural background. A truly robust global capitalism would ensure this minimum human capital development as a matter of sound economics. Legal and regulatory infrastructure should ensure the vindication of the economic values underlying the Universal Declaration of Human Rights through a reconfiguration of the IMF, the World Bank, and the WTO. Of course, the global economy needs other forms of legal and regulatory infrastructure to stabilize the global financial system. The Need for a Global Regulatory Infrastructure The lack of any reasonable regulatory infrastructure constitutes the final fatal flaw undermining globalization. Financial liberalization arose as a part of the deregulatory mantra of those controlling the destiny of our globalized economy. This meant that the global financial system ultimately resembled the patchwork regulation of the states prior to the New Deal’s federalization of financial regulation in the U.S.177 Developed nations learned from experience that capitalism can achieve high levels of macroeconomic growth only if regulatory infrastructure supports free markets. Financial regulation, deposit insurance, securities regulation, consumer protection, labor standards, social safety nets, bankruptcy protections, and environmental standards serve to secure the promise of free market capitalism. Elites set globalization on a path toward laissez-faire. Indeed, the course specifically prioritized financial market liberalization notwithstanding the fact that economic history taught that unregulated capital markets wobbled toward instability that fueled real economic crises.178 That financial instability materialized with a vengeance in 2007–9 as debt securities emanating from the deregulated U.S. financial system flooded the global financial sector and nearly caused the greatest financial meltdown in history. In late 2009, the United Nations entered the fray surrounding the causes and remedies of the global financial crisis of 2007–9 and the ensuing economic crisis. The UN commissioned a panel of experts (the Stiglitz Commission) to address the causes and make policy proposals to remedy the crisis, including economists and other experts from around the world with Joseph Stiglitz acting as Chair. The Stiglitz Commission found that the global economic architecture contributed to the crisis and needs reconfiguration. In particular, the current global financial system lacks any viable means of effective global regulation of the financial sector, thanks to the sway of special interest influence, backed by free market dogma.179 The Commission calls for a global financial regulatory body to advise the IMF, the WTO, and the World Bank and other international bodies on

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now that regulation evolve in accordance with the best economic science and learning available rather than in accordance with ideology or special interest influence. This yields a rather robust vision of financial regulation because of the sordid history of financial deregulation and the more benign history of the New Deal regulatory initiatives. Other commentators argue in favor of global harmonization and centralization of particular areas of law. For example, given that mortgage-backed securities lie at the center of the subprime crisis and that these securities landed in institutional portfolios across the world, one would expect some degree of reform energy on this front. Unfortunately, there has been a total absence of any initiative to reassess the legal framework governing the global distribution of securities. As discussed in chapter 1, securities regulation proved its economic benefits long ago. It seems that the global regulation of securities needs exactly that kind of New Deal reconstruction.187 Meanwhile, the legal academy languishes in an obsessive and narrow focus on free market efficiency. One cannot find a Law and Economics text that even discusses globalization, much less its central economic and ideological hypocrisies. The conventional learning on Law and Economics facilitates essentially the very market fundamentalism that Stiglitz and other economists hold is “bad economics” and ideologically driven.188 Specifically, that ideological movement essentially rejects government intervention or disrupting those enjoying privileges at the expense of the disempowered to forgo the cauldron of competition. It seemingly rejects all manner of regulatory infrastructure but the most basic elements of legal infrastructure—those relating to the enforcement of contracts and clear property rights. Until the Law and Economics movement recognizes the limits of free market doctrine, it will continue to lose touch with economic science and will ultimately be best termed law and pseudo-economics.189 Unfortunately, this laissez-faire approach to financial regulation continues to mark global financial regulation—the Dodd-Frank Wall Street Reform and Consumer Protection Act fails to address trade imbalances, global financial regulation, or global market development at all.190 I address this point more expansively in chapter 7. This chapter traces the winners and losers under the current legal framework governing globalization and demonstrates that reconstructing globalization can pay huge economic dividends. Those interested in robust macroeconomic growth and financial stability constitute the losers under today’s globalization, and corporate and financial elites once again emerge as winners—winners with little or no downside risk or accountability. While a precise accounting of the haul of the winners, and the money flowing out of the

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loans that lacked a reasonable basis for repayment and that involved defrauding borrowers through various illegitimate machinations. If the U.S. endowed itself with more optimal mechanisms for human capital formation, this pool of disempowered borrowers would not exist. The predatory loans involved raw racial exploitation, in which the most powerful profited from the misery they imposed upon the most disempowered parts of the U.S. population. Fourth, the continued toleration of racial politics fundamentally obscured economic interests and allowed law to veer back to discredited laissez-faire policies that operate to empower elites to the maximum extent possible. In a society burdened with gaping economic inequalities, economic oppression will follow, and always this oppression entails massive economic losses, as the subprime crisis illustrates. America’s racist legacy led to its dysfunctional meritocracy as well as subprime market development and regulation, human capital, and politics. These factors fueled all aspects of the subprime debacle. The Mythological American Meritocracy The tension between America’s vaunted meritocracy and the reckless and irresponsible misconduct giving rise to the financial crisis of 2007–9 raises obvious questions that few wish to address. The financial oligarchs holding our economic destiny in their hands (along with their cronies in government) engaged in either grossly negligent misconduct or very corrupt misconduct. For example, Jamie Dimon, the CEO of JPMorgan Chase, told the FCIC that his bank “missed” the risks of high-risk mortgages.4 That seems improbable, at best. The essential job of a banker involves identifying and managing risks. The alternative to missing such risks would be that bankers knowingly took massive risks on board to line their pockets at society’s expense. In fact, according to the FCIC, Wall Street coined a new term for this: IBGYBG meaning: “I’ll be gone, you’ll be gone.”5 Either way, the meritocracy broke down at great cost to all but a handful of senior managers in the banking sector. Race and other forms of irrational disempowerment fundamentally corrupt any putative meritocracy at work in America today. A meritocracy should operate much as other markets operate: to move human resources to their highest and best use so that the most able and trustworthy hold the most responsibility. “By excluding entire segments of the American population from equal access to opportunity, discrimination reduces competition” and allows privilege to fester instead of merit.6 Further, a variety of other selfperpetuating mechanisms continue to operate to advantage white males. The combination of socioeconomic status and racial privileges and disadvantages

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economists found that résumés with white-sounding names received 50 percent more callbacks than the résumés with minority-sounding names, after controlling for a variety of potential explanatory variables. The authors of the study conclude: “Our results must imply that employers use race as a factor in reviewing resumes.”14 Other studies suggest this dynamic operates with respect to female names—specifically, females with masculine-sounding names enjoy more opportunities than other females.15 Similarly, women with children suffer career detriments while men with children benefit.16 Even with respect to audit studies of apparently mundane transactions like taxicab tipping, scholars find evidence of a systematic bias in favor of whites.17 Women and minorities also suffer weaker evaluations in terms of performance ratings than white males even when raters view videos of job performance that are specifically scripted to be identical.18 A recent economic study on the effect of racism on the wage gap between African Americans and whites isolates the effect and concludes that 25 percent of the wage gap reflects the operation of racism.19 The bottom line here is that white males enjoy significant economic privileges with respect to market outcomes relative to the 50 percent of the population that is female and the 40 percent of the population that is minority. No wonder 95 percent of the highest-paid senior managers of Fortune 500 companies are white, and 94 percent are male.20 Many Americans start life with precious few opportunities to excel economically. Because of the crisis, more American children live in poverty.21 Now, about one in four young American children lives in poverty.22 Thirtynine percent of African American children and 36 percent of Hispanic children live in poverty.23 Only an immoral nation that disfavored economic growth could tolerate such a waste of human resources. Indeed, even before the crisis, the U.S childhood poverty rate of 22 percent ranked near that of Mexico, at the bottom of rich nations, and well below those of wealthy nations such as Finland and Denmark, with childhood poverty rates of just 3 percent. In terms of fielding our best, brightest, and most responsible leaders, the U.S. is at the bottom of the ladder.24 The American meritocracy utilizes only a fraction of its human resources and showers privileges upon a few. There is too much privilege and its mirror image, disempowerment, in the U.S. After all, in accordance with the theme of this book, every instance of elite privilege necessarily means a pro tanto degree of disempowerment. This chapter argues that disempowerment thereby reflects a pro tanto degree of privilege. Elites rigged the meritocracy just as they rigged law and regulation. A dim or corrupt elite runs America. The so-called meritocracy failed to ensure that the best and most trustworthy enjoy the greatest responsibility.

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financial elites that proved their ineptitude or corruption by crashing their firms “like lemmings off a cliff.”30 A World Awash in Economic Oppression A world that permits 2.6 billion people to live on less than two dollars per day cannot possibly deploy its human resources to the maximum extent possible.31 Yet, the global community seems oddly sanguine about this reality. The sheer randomness of the deep disempowerment of poverty ought to arouse suspicion that we live in a malconstructed world, wherein the luck of birth determines all and huge human potential simply festers, wasted and unknown. For example, in Mozambique, 15 percent of infants fail to survive their first year.32 In the U.S., 7 of every 1,000 babies die before their first birthday. The average citizen of Luxembourg enjoys (adjusted for purchasing power parity) buying power that is 62 times higher than that of the average Nigerian. Sub-Saharan Africa achieves educational attainment of 5.4 years of schooling, while the developed world achieves 13.4 years in far better schools.33 Yet for the most part little protest erupts as a result of these facts. If the fundamental injustice of this reality fails to arouse action, perhaps more widespread realization of the economic losses we each bear as a result of this deep disempowerment will. According to the World Bank, too much inequality plagues the world economy. “Equity is complementary  .  .  . to the pursuit of long-term prosperity. Institutions and policies that promote a level playing field—where all members of society have similar chances to become socially active, politically influential and economically productive—contribute to sustainable growth.”34 While too much equity can impede growth (as the communist experiment of the 20th century proved), too much inequality may reflect too much privilege and too much economic oppression, whereby a few enjoy insulation from competition through their control of law and others can never reach their full market potential because of deprivation of basic resources. Racial inequality and inequality in human capital opportunities constrict macroeconomic growth and impose costs on every citizen of the world.35 The World Bank argues that a combination of two inherently related realities grips the global economy and retards growth. First, too much economic potential languishes at the margin of the global economy, disempowered to innovate, produce, or contribute to a well-developed market to support a wider array of goods and services. Second, elites, holding sway over the construction of social policies and the distribution of wealth, too often work

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announced, the performance of the lower-caste students suffers; and if children are segregated according to caste, both the low-caste and high-caste children score even lower.40 The oppressive reality of standardized tests can be relieved. If the minority Baraku move from Japan to the U.S., their scores equalize with those of other Japanese test takers.41 When Finns emigrate from Sweden to Australia they perform on par with Swedes, as do Koreans relative to Japanese in America.42 Other studies show that while childhood poverty lowers standardized test scores, removing children from poverty can restore cognitive test performance.43 Thus, lifting conditions of social oppression eliminates disparities in cognition. The World Bank makes specific suggestions for using law to relieve economic oppression. The Bank recognizes that one solution does not fit all nations and each country necessarily faces a different cultural context. Nevertheless, in general, nations should consider programs designed to facilitate early childhood development. The Bank argues that the acquisition of economic capabilities by children should not be dictated by “circumstances of their birth.”44 For example, the World Bank points out that an experiment in Jamaica focused on remedying nutritional requirements for undernourished children. After twenty-four months of both nutritional supplements and intellectual stimulation, the undernourished children virtually closed the cognitive development gap relative to that of well-nourished youth. According to the Bank, “[i]nvesting in the neediest people early in their childhoods can help level the playing field.”45 Other areas the Bank identifies for productive investment include education, health care, and social safety nets. “Actions to equalize opportunities in formal education need to ensure that all children acquire at least a basic level of skills necessary to participate in society and in today’s global economy.”46 Health care supports human capital formation and productivity; seriously ill children cannot learn and seriously ill workers cannot produce at their maximum capability. Social safety nets can “spur households to engage in riskier activities” such as innovation or business formation. While funding for these programs risks taxation that could prove economically harmful, the Bank concludes that broad-based consumption taxes and progressive income taxes could fund these programs.47 More important, to the extent these programs support superior macroeconomic growth, they likely would generate more tax revenues greater than their costs, thereby leading to lower taxes over the long term. In fact, an economist found that generally higher tax rates to fund social spending along the lines recommended by the World Bank do not harm growth, and spending associated with enhanced worker productivity spurs growth.48

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and no other. This rule rests on social necessity, not science. It kept the slaves in slavery and allowed no person to avoid genocide for their children, despite reproducing with a nontainted group. Thus, racial laws in the U.S. as elsewhere just made up racial categories out of whole cloth, legally constructed as opposed to founded on any science at all.52 Professor Ian Haney Lopez highlights the role of law—not science—in the social construction of race. Under law, only “white persons” could qualify for naturalized citizenship in the U.S. prior to 1967. So, the Supreme Court needed to define whiteness. Whiteness has no geographic reality behind it for there is neither a country called Whiteland nor a City of White. Ultimately the U.S. Supreme Court defined whiteness as an exclusive racial category to which only a privileged few could accede. It turned on anthropology when its doctrine performed an exclusive role. Yet it turned on the understanding of the “common man” when that performed a more exclusive role than anthropology. Thus whiteness was more about exclusivity than science. Indeed, the Court specifically recognized the futile efforts of science to even agree to the number of racial categories.53 The legal construction of race once again was untethered to any scientific doctrine.54 Instead, “[r]ace is revealed as historically contingent, socially mediated systems of meaning that attach to elements of an individual’s morphology and ancestry.”55 In other words, race is made up—socially constructed—for social purposes unrelated to any science. Specifically, race is one means by which those with power profit from artificial social distance. The Europeans who captured slaves from Africa to sell in the American South were not geneticists; they were greedy businessmen who saw a profit opportunity. They sold slaves to make money, not to vindicate any racial hierarchy. Everywhere and always the existence of artificial social distance exists to entrench the power of incumbents. Race followed profits, or the political needs of those with power. In sum, race is all about power.56 As I mentioned in chapter 4, a new “transracialism” has dictated the course of globalization, which is specifically constructed in the wake of increasing social distance between economic elites and laborers throughout the global economy. Thus, the construction of globalization illustrates the point made here: Artificial social distance serves to enhance the power and profits of elites. Invariably, groups subject to racial oppression suffer impaired human potential under law. Laws operate to prohibit or impede the education or actualization of human resources. For example, after the formal end of slavery, the so-called Black Codes delivered the former slaves into economic peonage, under local ordinances and law. Later in the Jim Crow era, African

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All of these disparities necessarily mean restricted opportunities and messages from society regarding racial value. Thus, one would expect race to infect standardized test scores just as oppression infects so-called intelligence tests around the world. Social scientists have isolated stereotype threat (the internalization of society’s racial norms and expectations) as a persistent and testable suppressant of standardized test scores for students of color in the U.S.66 Moreover, the persistent racial disparities in health outcomes and poverty in the U.S. also likely operate to suppress performance on cognitive tests. After all, the World Bank highlighted how poor health negatively affected cognition tests for children in Jamaica.67 The poverty rate for black children is more than three times as high as for white children in the U.S.68 Students in ill health and suffering from poor nutrition will not score as high as their potential on standardized tests. Consequently, compelling evidence shows that so-called racial gaps in test scores both reflect and transmit oppression. The combined impact of stereotype threat, poverty, the mass incarceration of youth of color, and disparate health outcomes such as life expectancy distorts incentives in communities of color. Hopelessness and impaired life expectancy deter human capital formation.69 Cultural realities transmogrify over time into cultural norms and expectations. These racial disparities impose large macroeconomic costs, in terms of the diversion of massive funds from socially productive investments to the prison industrial complex that now exists to benefit from and encourage more incarceration. In short, the disparities in the U.S. reinforce themselves in a vicious cycle of economic oppression that mimics the pattern identified by the World Bank regarding the destruction of human capital through poverty and stereotype threat. Few of these socially significant racial disparities have materially diminished over the past thirty years.70 Race clearly still pervades our society today. The Costs of Economic Oppression Today in America In 2004, I estimated the costs to America of continued racial oppression. I first reviewed the economic evidence showing that race continues to hold sway in America. For example, the Nobel Prize–winning economist Kenneth J. Arrow describes the empirical record showing the persistence of irrational racial discrimination as “decisive.” “Especially striking are the audit studies on differential treatment in the housing and automobile markets.”71 Since then more compelling evidence has emerged that race still plays a powerful role in employment markets. These empirical studies stand in stark contrast to theoretical speculations that discrimination should be eliminated through the operation of market pressure in the long run.72

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Hispanics) demonstrates that as our minority population expands, the continued persistence of disparities becomes more costly.78 This estimate mirrors the assessment of McKinsey & Co. that closing the education gap between whites and minorities would expand U.S. GDP by 4 percent, which would today approach $600 billion in losses just from faulty human capital development alone (based upon estimated GDP of $14 trillion).79 By any measure, the economy sustains staggering losses from the continuing disparities in economic opportunities. Even these numbers, however, likely understate the costs of impeding people from actualizing their human capital in America. They do not include other racialized groups, such as Native Americans, and they do not include women, who continue to face a labor market that pays women laborers less than 80 percent of what men earn.80 It also is limited to economic impact manifest in the labor market. Infant mortality, excess incarceration rates, life expectancy, and a host of other social maladies that disproportionately affect communities of color all take a macroeconomic toll that has not yet been quantified. Based upon the foregoing economic studies and data, it is certain that race and other forms of economic oppression portend a long-term multi-trilliondollar American economic nightmare. These costs do not include the costs of an impaired meritocracy, discussed previously in the context of the subprime catastrophe, or the costs of exploitative conduct arising from power disparities and manifest by the predatory lending that drove the subprime crisis. Finally, the costs of economic oppression in the U.S. must include the impaired market development within the U.S. that led to an economy driven by debt rather than by innovation. Allowing a significant segment of the population to languish in poverty or jail limits the extent of the market. The Power of Cultural Diversity Of course, these losses constitute only the most direct costs of continuing to maintain a racialized society. Further costs include the losses relative to a society that not only takes affirmative action to resolve racial hierarchies but actually embraces the full potential of its human resources by seeking to harness cognitive diversity. Cultural diversity arises as a by-product of a racialized society, or from the different experiences of subgroups within a society, based upon a range of factors from gender to immigrant status. Cultural diversity can disrupt groupthink and affinity bias and can support superior creativity and cognition. Cultural diversity does not achieve these positive outcomes based upon morphological features but rather on different cognitive experiences and perspectives.

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operate together to cloud judgments and disrupt the operation of a true meritocracy at all levels of the American economy. The disruption of groupthink, homosocial reproduction, and affinity bias may well serve to explain the findings of empirical studies showing superior outcomes from group decision making by diverse groups relative to homogenous groups. For example, racially diverse groups achieved higher quality and feasibility scores for marketing plans than more homogenous groups.91 Similarly, with respect to boards of directors, financial studies find an association between board diversity and financial performance, even after controlling for firm size and industry and corporate governance practices.92 Similarly, firms with more board diversity pursued less subprime lending and suffered lower losses.93 A study from economics finds that the most diverse U.S. cities (measured by percentage of residents born in other countries) are the most productive cities measured by wages and rents.94 In the world of higher education, a recent meta-analysis of seventeen studies of the link between diversity (racial as well as nonracial) and enhanced cognitive skills for the entire student population found that “the evidence for the cognitive benefits of college diversity experiences is quite strong.”95 Despite the limitations of empirical studies, this evidence paints a compelling picture that cultural diversity can help a society make better decisions and achieve superior cognitive outcomes. The subprime crisis shows that the U.S. must diversify its top leadership to achieve new heights of competence and to reduce homosocial reproduction as well as affinity bias. Race, Economic Oppression, and the Subprime Debacle While the Civil Rights Act of 1964 and Brown v. Board of Education removed the harshest elements of American apartheid, the U.S. still permits too much racial oppression. The U.S. never committed sufficient resources to resolve its racial hangover and instead continues to pursue policies that inflict serious damage on disempowered communities such as the so-called war on drugs. As a result, instead of rationally educating our youth, the U.S. expends $25,000 per year incarcerating many nonviolent youths of color.96 The costs of pursuing such policies, as discussed previously, can be obscured because they tend to accrue silently in the form of lost economic opportunities and forgone output, rather than in dramatic financial calamities. Occasionally, deep or persistent economic oppression can lead to crises, such as the subprime mortgage crisis. Even before the crisis, authoritative voices warned that the exploitation of vulnerable communities, including communities of color, through predatory lending posed a growing danger.

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controlled for credit scores, regulatory authority, and a majority of credit risk variables that lenders themselves identify as important.105 Short of the lenders’ opening up their entire loan files (which they have lobbied against), the best evidence available leads to only one conclusion: Lenders steered a huge number of minority borrowers into unnecessarily expensive loans. This racial steering into subprime loans constitutes the most predatory type of lending, termed “reverse redlining,” as mortgage brokers, lenders, securitizers, investment banks, and others knowingly extracted extra market profits through racial exploitation. The U.S. Department of Justice has initiated a wide-ranging probe into reverse redlining. These inquiries mirror pending cases in state courts.106 Similarly, the Federal Trade Commission settled reverse redlining claims against Gateway Funding Diversified Mortgage Services. The FTC alleged (and Gateway stipulated) that this mortgage broker permitted its agents to levy surcharges against minority borrowers that caused such borrowers to pay more for loans solely based upon their race. In late 2011, in the largest fair lending settlement in U.S. history, Bank of America agreed to pay $335 million for discriminatory lending at Countrywide (which it had purchased) affecting 200,000 borrowers nationwide. Numerous similar cases are pending throughout the nation.107 At this point, the question is not whether lenders steered minorities into predatory loans; the only question is how many hundreds of thousands of minority borrowers ended up overpaying for their loans and their homes. Differential foreclosure rates suggest that a multitude did so. If a lender applies responsible and nondiscriminatory underwriting standards, then communities of color should have comparable foreclosure rates. Because of the losses implicit in foreclosure, even a few extra foreclosures out of one hundred borrowers could wipe out years of enhanced risk-adjusted interest for all one hundred loans. This means that although higher-risk loans may be expected to generate more foreclosures, highly divergent foreclosure rates suggest something else amiss. In Memphis, Tennessee (according to a lawsuit filed by several Tennessee municipal authorities), for example, 43 percent of Wells Fargo’s foreclosures were in African American neighborhoods, where only 15 percent of its mortgages were made. Yet, white neighborhoods, where Wells made 60 percent of its loans, accounted for only 21.5 percent of foreclosures. Former Wells Fargo employees attest that Wells Fargo encouraged targeting black borrowers for subprime loans throughout the nation.108 This pattern of racial differentials in foreclosures strongly suggests that Wells Fargo exploited communities of color in search of short-term profits (and higher bonuses for management). Wells ultimately settled a series of discriminatory lending cases for hundreds of millions in payments.

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same over this time. This all coincided with more rapid securitization of subprime loans and the peak of the “global savings glut” that Fed Chair Alan Greenspan identified as a key element underlying the subprime fiasco, as discussed in chapter 4. Put simply, the most reckless and exploitative phase of subprime lending appears to be driven not by the specific credit characteristics of the borrowers (or any other demand side element) but instead by the market power of the banks and the global demand for high-yielding product created by a fundamentally distorted global financial system. As more loans moved more quickly into the global financial sector, incentives for proper underwriting diminished and loan risks increased.114 Minority borrowers were fleeced because the lenders could get away with fleecing them and the global financial sector demanded that they do so. The profitability, even if illusory, explains the subprime boom between 2004 and 2006, not a charitable desire to help minority borrowers and the credit characteristics of the borrowers, which too often justified prime loans. The economic impact of the subprime debacle on communities of color continues to devastate entire neighborhoods, cities, and families. The home ownership gap remains as high as ever: In 1940, for example, 23 percent more whites than blacks owned homes versus 28 percent more today. Whites continue to enjoy easier access to conventional home loans, at all income levels. Even among high-income borrowers, three times more Latinos and African Americans service high-cost loans than white borrowers. Subprime loans carry a much higher risk of foreclosure. Today, 10 percent of African Americans face foreclosure versus 4 percent of white borrowers. With 9 million more foreclosures yet to come over the next three years, these trends mean massive destruction of wealth within communities of color. Thus far, the subprime crisis has destroyed between $164 billion and $213 billion of wealth within communities of color.115 Many warnings of misconduct in the subprime mortgage market emerged from 2000 to 2007. Regulators and lawmakers simply ignored all the signs of trouble. The explosive growth of subprime lending from 2000 to 2004 hardly occurred in secret. Further, the deregulatory mantra beginning in the 1980s also did not occur without warnings regarding the risks of precipitous deregulation of the financial sector. This raises the question of why the system responded in such a subdued, even invisible fashion. Racial Politics and the Subprime Fiasco The MIT economist Simon Johnson and James Kwak have written about the massive increase in the size of the financial sector in our economy. As

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debate; the fair debate essentially suffocated in Philadelphia, a victim of the so-called Southern Strategy. To be fair, Reagan hardly needed the Southern Strategy in the end, as he swept not only the South but also the West, the Midwest, and the Northeast in a landslide victory over President Jimmy Carter. Yet, the consequences of his vision of highly limited government immediately paved the way for much of the predatory lending at the root of the subprime crisis. In 1982, he signed the Garn–St. Germain Depository Institutions Act,122 which operated to expand the availability of adjustable rate mortgages and eliminated mandatory loan-to-value ratios and negative amortization loans.123 In 1984 the Secondary Mortgage Market Enhancement Act124 became law, clearing the way for more expansive private securitization of mortgages (including predatory mortgages) by preempting state securities law and authorizing a variety of financial institutions to invest in such securities.125 It is hard to imagine that the large numbers of working-class whites (even in northern cities) who voted for Ronald Reagan really supported these laissez-faire predicates to the subprime fiasco, as opposed to feeling that the Democratic Party was too closely aligned with the interests of African Americans and other minorities. The work of the pollster Stanley B. Greenberg illustrates the point: He found that many of the so-called Reagan Democrats deserted the Democratic Party because they identified the Democrats as the party of the poor and minorities.126 Indeed, these voters “expressed a profound distaste for blacks.”127 Race operates in other ways to distort politics. The economist Glenn Loury, in The Anatomy of Racial Inequality, carefully studied the mechanisms that produce racial inequality even in the absence of an intent to discriminate on the basis of race. One mechanism he identifies is racial stigma. Racial stigma arises from deeply held but largely unspoken attitudes of racial inferiority or superiority. These attitudes do not cause any particular harm, except for the effect on the nation’s political discourse. Thus, for example, Loury posits that the sanguine response of the American body politic to the incarceration rate in the U.S., including the very large number of youths of color in the criminal justice system, could be accepted only by voters who supposedly value justice, freedom, and fair opportunity for all, because of notions of racial inferiority. Our society incarcerates African American males at seven times the rate of white males, and this patent injustice warrants nary a blip on the radar of the body politic. Only a powerful social construct like race can explain the cognitive dissonance of society on this issue.128 Predatory lending similarly failed to register at all with the American body politic. For example, in 2004, neither the Republican nor the Democratic platform even mentioned predatory lending, subprime lending,

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racialized politics played a substantial role in bringing about the crisis and amplifying its destructiveness. In sum, race contributed to the subprime debacle in four fundamental ways. First, as discussed in chapter 4, elites rigged globalization to rely upon consumption centered in the U.S. and founded on debt, yet global economic oppression and the construct of race in America precluded any broader market development and human capital formation to secure consumption. Second, race prevented full actualization of human resources in the U.S. and allowed an elite produced by pervasive privilege and unaccustomed to real competitive pressures to game the financial sector the same way they gamed the college admissions process—they win no matter what, and the rest of us lose. Third, the continued sway of race left a disempowered subclass in place that invited exploitation, and predatory lending followed. Finally, race fundamentally polluted the body politic so that laissez-faire could grip our system without the body politic’s really bargaining for it—instead, these voters voted against a party seen as too closely aligned with the interests of minorities, and the GOP exploited this for forty years to the maximum extent possible, as admitted by two party chairmen. Furthermore, the body politic seems not to have reacted appropriately to warnings of race-based predatory lending. As emphasized throughout this book with respect to every putative cause, race did not exclusively cause the subprime debacle. Many factors combined for the crisis of 2007–9. Those peddling a single explanation to the crisis risk simplistic and reductionist explanations. Most notably, extreme conservatives frequently blame the government’s efforts to further affordable housing and home ownership as the exclusive cause of the crisis. At times, these arguments flirt with outright racial scapegoating.135 A Federal Reserve study found that only 6 percent of all subprime loans qualified to fulfill bank obligations under the Community Reinvestment Act.136 As previously stated, Fannie Mae and Freddie Mac invested in nonprime MBS, but losses on these investments from 2008 to 2011 total only $3 billion.137 These losses pale in comparison to losses suffered in the riskiest lending and can mean only that Fannie and Freddie did not invest much in the highest-risk mortgages. Three of the four Republican members (and all of the Democratic members) of the Financial Crisis Inquiry Commission declined to attribute primary or exclusive causation to the CRA, affordable housing goals, or the government-sponsored enterprises at the heart of the home mortgage market—Fannie Mae and Freddie Mac. Instead, all nine of these Commissioners concur that Fannie and Freddie played only a modest role and attribute the crisis primarily to an extended list of other causes.138 Thus, the view that affordable housing goals somehow caused bankers to gorge on risk (and

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limitations regarding race-based decision making. This could prove economically valuable in generating ideas because diverse workgroups consistently outperform nondiverse workgroups in accordance with Irving R. Janis’s groupthink theory. In addition, diversity should operate to disrupt affinity bias in areas where elites entrench themselves through homosocial reproduction.142 I proposed a range of legal innovations to support wider embrace of cultural diversity including a safe harbor under Title VII antidiscrimination law.143 Most notably I proposed that diversity in the boardroom of the publicly held firm could lead to superior corporate governance outcomes as shown in numerous empirical studies. Given the importance of embracing diversity for profit, I argued that the federal securities laws should mandate that public firms disclose their diversity policies.144 Lani Guinier and Gerald Torres, in The Miner’s Canary, argue that a transracial coalition of those oppressed by holders of concentrated economic and political power should come together to achieve reform. They suggest that the Texas plan to admit the top 10 percent of every high school class to the state’s flagship university epitomizes the potential for this type of coalition.145 Professor Richard Delgado challenges this vision of a transracial coalition to achieve racial reform. According to Delgado, “coalition is likely to founder on cultural misunderstandings or historical grievances, and to encounter internal defections and efforts by the dominant group to split the coalition.”146 History certainly suggests that Delgado is right. Yet the election of 2008 resulted from a broad coalition of voters of color that propelled an African American into the White House even though a majority of white voters cast their votes against Barack Obama. In chapter 7, I will address this issue in greater depth. Right now, I wish merely to suggest that deep social reform, of the kind needed to address the underlying causes of the great market meltdown of 2008, is likely to require a vast array of interests to oust the very concentrated interests that I posit have rigorously entrenched themselves at the apex of our economic and political system. In other words, I ultimately seek to extend the Guinier and Torres approach beyond race and into broader legal and regulatory reform. At some level, law simply cannot change the power dynamics within any society—including the constructs of race and economic disempowerment. Instead, a cultural suspicion of deep economic disempowerment must emerge. People must recognize that disempowerment of others means constricted demand for their own services and money out of their own pockets. Instead of feeling threatened by the disempowered, a cultural consensus of citizens must emerge that understands the threats of concentrated economic power. Citizens must recognize the extreme unlikelihood that the

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and tomorrows.” Yesterday’s profits invariably lead to an underpricing of risk today, with a consequent crash tomorrow when risk becomes an adverse reality.11 In short, the Minsky thesis essentially predicted the subprime debacle. Regulators and policymakers should therefore assume that markets tend toward instability, as history certainly proves this central point. Government regulation must err on the side of caution as well as impose redundant systems to ensure the stability of the system. Since the date of Greenspan’s speech, the complexity of the global financial system has increased. Consequently, the need for ever more optimized legal frameworks to secure government’s crisis management efforts is ever more compelling. This chapter articulates legal frameworks securing precisely these kinds of governmentsponsored stabilization efforts. In modern capitalistic societies, government must respond to financial crises and other economic disruptions or risk economic contractions and the wrath of voters. This implies massive government intervention into the economy. This reality means that law faces a challenge to organize government’s economic interventions through optimized legal and regulatory frameworks.12 Once again, this chapter demonstrates that excessive economic and political power corrupts sound policy in the absence of legal limits, at great expense to growth and stability and by extension to society generally. In terms of stabilization policies, government enjoys three channels of influence: monetary policy, fiscal policy, and firm bailouts. Monetary policy relies upon expansion of the money supply, usually through expanded bank credit, to stoke demand and quell economic downturns. Fiscal policy seeks to replace slack in demand with enhanced government spending. Bailouts involve the use of government resources to stop economic contagion and control systemic risk from the failure of large or interconnected firms. In the crisis of 2007–9, each of these stabilization instruments played a prominent role in the government’s response. Moreover, each of these instruments suffered from a suboptimal institutional structure as well as inappropriate political subversion. In what can only be termed an epic effort, the government deployed massive financial resources to stemming the downturn, particularly during the fall of 2008 and the spring of 2009. The government assumed potential obligations of $23 trillion and made massive outlays that continue through today and long into the future.13 The Federal Reserve extended more than $16 trillion in loans to save the entire global financial system.14 It also purchased $1.25 trillion in mortgage-backed securities from the financial sector to prop up real estate values.15 Furthermore, Congress provided $700 billion through the Troubled Asset Relief Program to recapitalize the

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therefore act as a key “transmission belt” of monetary policy.24 If banks lend, then more money can be spent to support economic activity. The Federal Reserve can induce more borrowing through interest rate cuts. When interest rates fall, loan demand increases. The Federal Reserve maintains direct control of a bank’s cost of funds through its control of the Federal Funds rate. That rate governs the costs of loans made through shortterm interbank loans. The Federal Reserve also influences interest rates through its open market operations conducted through the Federal Open Market Committee. When it buys government bonds, it injects reserves into the banking system, and buying bonds on the open market increases the demand for such instruments, causing bond prices to go up and yields on such bonds to fall. Yields fall because the increased demand for government bonds means more buyers, who will accept lower yields in order to obtain bonds in demand. Lowering yields (i.e., interest rates) on debt and injecting more reserves into the banking system spur lending. This gives the Fed tremendous power over the pace of economic activity.25 Modern monetary policy dates to the Great Depression. One traditional explanation for the depths and persistence of the Great Depression involves the Federal Reserve’s sloppy administration of monetary policy.26 Commentators have long maintained that the Fed followed an expansionary policy prior to the Depression that fed the speculative frenzy, and a contractionary policy after the onset of the Depression. In particular, the Fed apparently raised interest rates in order to enhance bank earnings, as banks held vast amounts of bonds. This increase in interest rates caused a continued contraction in economic activity.27 Thus, an essential part of the New Deal involved placing monetary policy on a firmer legal framework that could resist special interest influence, and particularly the influence of the banking industry.28 More specifically, after the New Deal banking reforms, the governors of the Federal Reserve Board enjoy fourteen-year terms, the staff of the Federal Reserve System earns competitive salaries, and the Federal Reserve Board may levy assessments on member banks—meaning that the Fed is a selffunded administrative agency unbeholden to economic interests or the political branches. Prior to the New Deal, the Secretary of the Treasury and the Comptroller of the Currency served on the Federal Reserve Board, but the Banking Act of 1935 terminated their membership. The New Deal reforms aimed to reduce the influence of special interests on monetary policy. For the most part, monetary policy since these reforms appears driven by economic science and expertise.29 Nevertheless, the Fed may benefit further from an explicit charter to lean against dangerous asset bubbles. Mass mania inheres in the creation of an

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of each regional Federal Reserve Bank and retains approval power of each regional bank’s president. The presidents of the regional banks hold five of twelve positions on the Federal Open Market Committee, which oversees one element of monetary policy—the purchase or sale of government bonds in the open market.34 Thus, the Board of Governors dominates monetary policy, not the regional banks. Nevertheless, the banking industry itself plays a powerful role in the Federal Reserve System. The members of the Federal Reserve System—which are all private commercial banks—elect a majority of each regional bank board. These boards then elect regional bank presidents—all of whom are attendees of each Federal Open Market Committee, and five of whom actually cast votes at such meetings. At the very least, this raises the specter of cognitive capture, as the representatives of the banking industry mingle freely as peers with the Federal Reserve Board of Governors at the critical FOMC meetings, and beyond. Professor Minsky argues that it is “difficult to discover or invent a serious reason for the existence of twelve Federal Reserve Banks.”35 Essentially, one Federal Reserve Bank should act as an agency of the Federal Reserve Board, with a completely public governance structure. This reform negates the prospect of agency capture inherent in private ownership of the Federal Reserve Banks. The current influence of private banks smacks of corruption.36 To be fair, the Fed needs to comprehend the dynamics facing the banking industry in order to conduct monetary policy, for banks act as the transmission belt of monetary policy through their lending activities. Such a facility exists separate and apart from the Federal Reserve Bank system. The Federal Advisory Council (FAC) exists for the very purpose of creating a forum for bankers to exchange information with the Fed. Scholars studied whether the FAC operated as a means of inappropriate industry influence over monetary policy and concluded that it did not.37 Thus, the FAC, rather than the Federal Reserve Bank System, should function as the focal point of exchange between the Fed and the banking industry. Indeed, the Fed itself identifies this as the primary role of the FAC.38 This approach seems more likely to avert cognitive capture than the current approach. That potential for capture traditionally seemed immaterial to the conduct of monetary policy, as both the Federal Reserve Board and the banking industry possessed broadly aligned interests in a sound currency, low inflation, and macroeconomic stability, if not full employment. The financial meltdown of 2008 illustrated the dangers of the position of industry representatives at the heart of the Federal Reserve System. For instance, the Fed commenced paying interest on bank reserves held within the Federal

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policies at the Fed that spawned the credit bubble of 2003 to 2007. The trajectory of gross debt within the U.S. since 1980—from 160 percent of GDP to as high as 375 percent of GDP prior to the crisis—shows that overreliance on monetary policy entails real risks in the form of excess debt.44 Much controversy surrounds the issue of whether the Fed kept rates too low for too long. Between 2004 and 2008, the Fed lost control of long-term interest rates, including mortgage rates. Even when the Fed raised short-term rates, long-term rates declined based upon diminished inflationary expectations.45 As explained in chapter 4, much of the problem here relates to the massive flow of capital from China and other surplus countries into the U.S., where it funded and subsidized unsustainable consumption fueled by a mountain of debt.46 In the next section, however, I argue for a more robust fiscal policy function that could help reduce reliance upon debt-driven monetary policy. Fiscal Policy Professor Hyman Minsky argued that “[p]eriods of stability (or of tranquility) of a modern capitalist economy are transitory.”47 Additionally, “the inherent instability of capitalism is due to the way profits depend upon investment . . . and investment depends upon the availability of external financing. But the availability of financing presupposes that prior debts and the prices that were paid for capital assets are being validated by profits.”48 Thus, debt destabilizes an economy, and the more debt an economy holds, the more dangerous the potential destabilization. The reliance of monetary policy upon the accumulation of more debt means that monetary policy cannot operate as the sole means of meeting economic disruptions. First, the excessive accumulation of debt within the financial system itself creates instability. As debt burdens increase, debt’s stimulative effect weakens because more must service prior debt.49 At some point, investors deem debt accumulation unsustainable, and the supply of credit contracts rapidly. Minsky theorized in Stabilizing an Unstable Economy that credit cycles driven by natural human psychology inhere to capitalist economies. The credit bubble and housing bubble exemplify Minsky’s focus on the excessive optimism, validated through the realization of profits, which in turn feeds into a more optimistic outlook. Nonetheless, a crash is the ubiquitous outcome for every asset bubble. Suddenly credit disappears even for worthy borrowers as an excessively pessimistic view takes hold.50 Thus, 2003–7 gave rise to 2008–10, in accordance with Minsky’s thesis. Second, at some point, because of a major disruption such as the failure of a systemically important financial institution or a bursting asset bubble or a

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legislation.61 Within these broad outlines, Minsky encouraged more thinking about how to secure an effective government-stabilization program like those the government administered “in the not too distant past” because “Big Government is here to stay if we are to avoid great depressions.”62 Virtually all commentators agree that fiscal policy operated to end the Great Depression when World War II triggered massive government expenditures. Furthermore, compelling evidence shows that in the postwar period countercyclical fiscal policy operated to blunt downturns in investment in 1974–75 and 1981–82. Notably, corporate profits benefited from countercyclical fiscal policy during these downturns and suffered in 1929–30 when government surpluses exacerbated a downturn in investment.63 The economist Richard Koo demonstrates the powerful benefits of steady fiscal stimulus during the 1930s in Germany—when unemployment plunged from 26 percent to just over 2 percent.64 More recently, in the crisis of 2007–9, China responded quickly to a potential crisis in its incipient capitalist system with a classical Keynesian approach—a massive fiscal stimulus in the form of infrastructure investment. Indeed, China pursued “perhaps the biggest peacetime stimulus ever.”65 Chinese Premier Wen Jiabao states that “from both the near and long-term perspective and in both the real economy and the fiscal and financial field, our stimulus package, policies and measures are timely, forceful, effective and suited to China’s realities.” Further, the stimulus package “will bring benefits to both the current and future generations and serve the interests of the world.”66 This has resulted in a continued boom in China that proves again the utility of fiscal stimulus in the face of a downturn.67 Notably, this vision of government-sponsored investment in the face of falling private investment ought to result in self-liquidating government expenditures. More specifically, the government’s expenditures as investor of last resort, if properly structured under law, should result in outlays that enhance future productivity and future tax revenues.68 If the government can direct its investments into projects that yield aggregate benefits in excess of government costs (including its cost of capital, which should be low as a result of the aforementioned risk aversion), then government’s investorof-last-resort activities should be costless while simultaneously reducing the long-term risk that investors face arising from recessions. Empirically, little doubt remains that properly structured government interventions may enhance worker productivity and thereby generate more growth than outlays.69 Indeed, programs like the GI Bill educational benefits prove that government tax revenues alone may exceed government outlays by many times.70 Because of the centrality of ideas and human capital to economic growth, it comes as no surprise that economists also find that investment in

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this type of fiscal shock and awe maximizes the fiscal multiplier of government expenditures because it breaks the deflationary conduct of consumers and businesses that cause them to prefer building cash reserves or repaying debts.81 Under this view, perhaps the greatest contribution of massive fiscal stimulus (like World War II) is that it inspires those hoarding cash to employ it productively. Unfortunately, Koo also shows that fiscal policy (and accompanying deficits) inspires political opposition because leaders rarely get credit for averting a disaster and because half-measures, in particular, can be portrayed as wasteful government expenditures that will lead to larger taxes at some point.82 Governing elites thus face temptation to favor long-term tax minimization rather than long-term growth. Indeed, the U.S. suffers from a leadership crisis in that its governing elites refuse to support economic growth and invest in the public goods every economy needs to remain competitive. According to the OECD, the U.S. pays less in taxes than any other developed nation except for Mexico, Chile, and Turkey. Nations that rate higher than the U.S. in the United Nations Human Development Index (Norway, Australia, and the Netherlands) pay more in taxes.83 These nations also do not bear the heavy burden of defense expenditures that the U.S. economy bears. The U.S. spends nearly $700 billion annually on defense, more than the next ten highest-spending nations combined.84 Historically, the U.S. paid more in taxes than it does today. Today the U.S. pays about 24 percent of its GDP in taxes. In 2000, the U.S. paid nearly 30 percent of its GDP in taxes at the same time that employment in the U.S. reached a historic peak. In 1965, the U.S. paid the same proportion of its GDP in taxes as the OECD average; today, the U.S. pays 10 percent less than other developed nations.85 Amazingly, despite this modest sense of public obligation and patriotism, after the election of 2010 the political leadership of the U.S. extended the Bush tax cuts to flirt with another debt crisis.86 Elites in the U.S. evince more commitment to low taxes than to funding macroeconomic growth. Unfortunately, the U.S. never imposed a disciplined or rationalized legal framework for government investment. In 2002, I proposed that the U.S. create a new legal framework for fiscal policy that extended the depoliticized legal framework governing monetary policy to countercyclical fiscal expenditures. I suggested a depoliticized agency with the power to direct government investment to the highest and most productive use based upon economic science (instead of purely politicized allocation from Congress) and to modulate expenditures in response to macroeconomic conditions. This would ensure that government investments benefited from a low cost of capital and packed the largest macroeconomic punch possible. It would

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typically fare poorly in bankruptcy too—their claims are subject to an automatic stay and are usually paid out in the form of newly issued equity securities by the reorganized firm.98 Thus, bankruptcy proceedings eliminate issues of moral hazard as unsecured creditors are put at risk of loss, and management contracts (for bonuses, golden parachutes, and deferred compensation such as retirement) are treated as just another creditor claim. On the other hand, bankruptcy should not be confused with liquidation; in fact, Chapter 11 reorganization specifically promotes the ongoing operations of the firm by staying collection activity (which may otherwise prove disruptive) and making special financing available.99 Neither bankruptcy nor FDIC receivership law contemplated the enormous bailouts of 2008–9. Firms often seek protection outside of these regimes. Capital from the government can always spare a firm from failure. Economically, government assistance to private businesses may produce benefits that exceed costs, at least in theory. Temporary market paralysis can deprive a business of capital resources in unpredictable, even irrational ways. These conditions could destroy firms with positive net present value but for severe market turbulence. Thus, in the past, the government successfully bailed out firms such as Chrysler and even earned a profit on its investment. But even if the government earns a profit from a bailout it may still create perverse incentives that prove very costly throughout the economy for an extended time period. Specifically, the government should never reward inept or reckless firm management and the government should never shield unsecured creditors from the market discipline that the risk of loss engenders. Thus, a critical element of a rationalized bailout regime must punish managers for steering their firms into insolvency and impose risks of loss on creditors. Without these elements bailouts can operate to entrench politically powerful corporate elites and force competitors to operate at a disadvantage in terms of cost of capital.100 Manifestly, government assistance for failed management teams and riskinsensitive creditors operate to reward ineptitude in defiance of capitalist norms. In the crisis of 2007–9, bailouts played a central role. Arguably, the most stunning development of the crisis of 2008–9 involved the massive deployment of government resources to save the financial sector. The bailouts started with the Federal Reserve’s facilitation of JP Morgan Chase’s acquisition of Bear Stearns in March 2008—at a taxpayer cost of $35 billion. Next, in September 2008 the government assumed control of Fannie Mae and Freddie Mac, at great cost to taxpayers (up to $685 billion) and great benefit to banks that held the great weight of securities issued by the governmentsponsored entities.101 This failed to reassure markets, and a few days later

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of TARP failed in the House of Representatives.106 Campaign contributions played a key role in determining the likelihood of a given congressional representative’s supporting the bill, along with the presence of financial services businesses in a given representative’s district.107 These conditions demonstrate the need for a formal bailout regime to displace the possibility that Congress might face the possibility of a legislative shakedown. The bailouts as structured enjoyed little support from mainstream economics. The former IMF Chief Economist Simon Johnson asserted that the megabanks simply exercised their excessive political power to obtain “grossly favorable” terms in the bailouts.108 The NYU economist Nouriel Roubini claimed that the bailouts amounted to “socialism” for the benefit of the “rich and well-connected.”109 Joseph Stiglitz maintained that the bailouts would worsen the “preserve incentives” that precipitated the crisis.110 The key problem, according to economists such as Paul Krugman, revolves around the ability of the bailed-out banks to supply credit to the economy; so-called “zombie banks” will hoard capital rather than lend. Krugman as well as others did not claim that the government rescue itself created the problem.111 The challenge always revolved around how to structure the financial rescue, and economists offered a range of options, such as creating new well-capitalized banks that could ignite lending and ultimately be sold to private investors. Only new banks with new managers and “pristine” balance sheets can restore normal credit flows to the economy.112 In fact, economic science demonstrated the elements of successful financial rescues. Managers should never benefit from rescues; instead, the bankers should be dismissed, so that full loss recognition may proceed. If management retains its control of the firm it is apt to cover up losses to maintain the veneer of success to the extent possible and to avert deeper insolvency. New management will want a clean slate and will therefore face incentives to write down all possible losses, which will be charged to the conduct of prior management. Moreover, if new management recognizes losses today, such losses will not be charged against future profits.113 Loss recognition means that borrowers can negotiate with lenders based upon reality rather than upon obstinate refusal to recognize losses. Forcing banks into bankruptcy or receivership thus facilitates deleveraging—first, creditors are forced to reckon with losses, and then the bank can forgive debts that realistically are not recoverable. Investor (shareholders and unsecured creditors other than depositors) claims should be wiped out in order to free bank assets for new lending. The quicker this resolution process occurs, the quicker lending can return to normal. In the bailouts of 2008–9, the government “did not force out a single CEO of a major commercial or investment bank, despite the fact

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government-sponsored bailouts revolves around how bailouts are structured and when government bailouts are triggered. Government-sponsored bailouts should provide certain disincentives for firms to avert government bailouts. As shown in chapter 2, in the U.S., public firms (the largest firms in the American system) tend toward CEO primacy. In other words, the CEO exercises a large degree of autonomy over a firm’s operations. Consequently, no firm is likely to become so big that TBTF applies without the acquiescence of the CEO. Bailouts should be structured to ensure that senior managers avoid the temptation of becoming TBTF. There is, after all, no economic compulsion for a firm to be TBTF. Empirical data suggests that economies of scale vanish well before a firm becomes TBTF.122 For example, in the banking sector, economies of scale disappear after a bank reaches about $10 billion in assets.123 Therefore, firm CEOs can keep a firm below the TBTF threshold without compromising economic performance. One means of assuring that CEOs face proper incentives to avoid TBTF status is to require the termination of all the senior managers and board members of any bailed-out firm. Typically, termination of senior management means that the vast majority of workers at a firm remain in place. The senior managers can hardly be deemed essential to the continuing operations of the firm; in fact, these are the very managers that destroyed the firm. Moreover, if highly paid senior management is retained, senior management’s incentive would be to cover up the extent of their recklessness to keep the firm on the government dole. New managers would want to recognize all losses immediately so that future earnings would not be diminished by buried losses. This would facilitate a rapid return to health and avoid the problems posed by “zombie” firms. Zombie firms exist only as a result of government largesse. Such firms become highly risk averse because they understand the problems hidden within their balance sheets and hoard capital to protect against future expected losses.124 Many Western banks—in the U.S. and Europe—qualify today as zombie banks.125 Another means of discouraging managers from seeking TBTF status would be to discharge employment agreements between bailed-out firms and senior managers and directors. Employees should not attain windfalls at the expense of the taxpayer. Senior managers did not bargain for government guarantees and therefore should never receive protection from the government for compensation agreements. The alternative would create perverse incentives: As business sags, the senior managers would prefer insolvency in order to achieve government-guaranteed payouts. Further, such an arrangement creates yet another asymmetric incentive for risk. Senior managers

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TBTF status face real economic costs to achieving such size and complexity that the government faces economic compulsion to shield their firm from the full consequences of its own misconduct. Managers will no longer seek to become TBTF. We know that managers frequently lead their firms into valuedestroying mergers and acquisitions. We know that compensation structures frequently encourage this economically inefficient behavior because managers of large firms are paid more. We also now know that such firms can threaten the entire global economy. Yet managers greatly benefit from TBTF. The regimen articulated herein should operate to disrupt this pernicious behavior by directly altering the incentives managers face to become TBTF.128 So why have no proposals for such financial reforms emerged? According to Senator Dick Durbin of Illinois, the Majority Whip, the banking industry is the “most powerful lobby” in Congress and “they frankly own the place.”129 Congressman Collin C. Peterson of Minnesota, the chair of the House Agriculture Committee, maintains that bank regulation is problematic in Congress because “[t]he banks run the place.”130 President Obama pledged that his administration would include no lobbyists and then promptly waived his own new rules so that a former Goldman Sachs lobbyist could be the Chief of Staff for the Secretary of the Treasury.131 In the election of 2008, the banking and investment banking industry contributed to both the Democratic and Republican candidates: According to Opensecrets.org, Senator John McCain’s top five campaign contributors were all large financial institutions.132 Senator Barack Obama received even more contributions, from essentially the same financial firms, totaling more than $3.5 million.133 Financial interests as a whole spent $450 million to lobby policymakers in 2008.134 In 2009, after receiving massive government support, they spent hundreds of millions more, increasing their spending by 12 percent over 2008.135 Lobbying expenditures and campaign contributions do not tell the complete tale of the influence of the large banks. The revolving door between Wall Street and the government spins elites back and forth between the regulated and the regulators at a dizzying pace. Consider just the movement of people from Goldman Sachs to government over the past three administrations: Robert Rubin, Treasury Secretary under President Bill Clinton; Henry Paulson, Treasury Secretary under President George W. Bush; Senator Jon Corzine of the Senate Banking Committee to governor of New Jersey; Neel Kashkari, the head of the Troubled Asset Relief Program (TARP); Joshua Bolten, Director, Office of Management and Budget and Chief of Staff to President Bush; Stephen Friedman, Director, National Economic Council under President Bush; Gary Gensler, Undersecretary of Treasury under President Clinton; Robert Steel, Undersecretary of Treasury under President

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Simply stated, to avoid future bailouts, bailouts must be highly punitive to senior mangers. A modern economy requires an advanced legal framework for crisis management. This framework must achieve four primary goals. First, the legal system must create a framework for rationalizing the government assistance so that only firms (including banks) that will generate sufficient long-term profits to justify support can obtain government assistance. Second, firms which fail to meet that economic viability threshold must be liquidated in an orderly process under law so that their assets may be transferred (free of equity and debt claims) to the highest bidder, and deleveraging may proceed. This is especially necessary in the financial sector, where risk-averse banks are likely to block effective monetary stimulus policy. Third, managers must be accountable for reckless or unsafe and unsound practices that compromise the viability of their firms. Fourth, an advanced economy needs a depoliticized authority to oversee any bailouts backed with government resources. Combined with the disincentives applicable to managers, discussed previously, bailouts will return to relative rarities reserved for extreme market conditions. The political energy for these reforms would by definition be weak. If bailouts are doled out in accordance with political power, a depoliticized regimen will not attract much in political support. Similarly, a depoliticized fiscal policy function would strip significant power from the political leaders currently presiding over fiscal policy. Nevertheless, in the 1980s the savings and loan crisis was resolved largely free of political influence and in a manner that controlled the cost to the government and minimized disruptions to credit markets. Moreover, the resolution of the savings and loan crisis exacted retribution on errant managers. Throughout the crisis, the megabanks grew. Bank of America grew by a third to $2.7 trillion in assets. JP Morgan Chase grew by 25 percent to $2 trillion. This girth opened up new avenues for profits. Indeed, volatility itself, like bubbles, generates huge profits (and bonuses) to the megabanks and their senior managers. In 2009, the stock market crashed to new lows in March and then marched back rapidly thereafter. Combined with all their subsidies, the market volatility paid off handsomely for the banking elite. In the first half of 2009, Goldman Sachs set aside $11.4 billion for bonuses, or the equivalent of $750,000 per annum per employee. This return to business as usual, with the U.S. taxpayer subsidizing the risks of the financial sector, threatens more market instability into the future, as the financial sector seems certain to pursue ever more risk. This cannot be termed capitalism—instead,

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reasonably be expected to pull the trigger on the orderly liquidation authority—and that may occur only after decades of the scourge of TBTF. So rather than an orderly liquidation, the same disorderly bailouts of the fall of 2008 will repeat themselves in the event of a megabank solvency crisis. Dodd-Frank facilitates this through formal authorization for both the Fed and the FDIC to assist foundering megabanks outside of the orderly liquidation authority. Indeed, the Act directs the FDIC to put a “widely available program to guarantee obligations of solvent insured depository institutions or solvent depository institution holding companies (including any affiliates thereof) during times of severe economic distress” in place “as soon as practicable.”148 The Fed must create emergency programs with “broad-based eligibility” for loan facilities “as soon as practicable.”149 Thus, every bailout that occurred in 2008 may continue to take place after Dodd-Frank pursuant to these expanded bailout powers. Perhaps the behavior of the credit markets demonstrates this best. Since Dodd-Frank the credit ratings agencies continue to give the megabanks a multi-notch upgrade based upon the prospect of government assistance for such banks. According to Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, the credit rating agencies give the five largest megabanks an upgrade of up to eight notches based upon perceived government backing, and the average of the five largest banks is a four-notch upgrade. This saves the banks 360 basis points (3.6 percent) on debt with a maturity of seven years. This amounts to a multi-billion-dollar federal subsidy for the megabanks.150 This subsidy took root at a time when the funding needs for economic growth suffer deep neglect and 25 percent of our children live in poverty. This government subsidy epitomizes the corruption of our government, our moral vacancy, and the economic backwardness of the U.S., all at once. This lawlessness undermines the rule of law itself, as market participants see these wild indulgences of elite power for what they are: an unlevel playing field. In conclusion, when it comes to monetary policy, fiscal policy, and bailout authority, those seeking to profit from bubbles, low taxes, and TBTF subsidies won the day with Dodd-Frank, and economic rationality perished. The highly profitable status quo prevailed—for a small handful of financial elites.

7 The Potential for an Economic Rule of Law The history of human improvement is the record of a struggle by which inch after inch of ground has been wrung from . . . maleficent powers, and more and more of human life rescued from the iniquitous dominion of the law of might. John Stuart Mill (1850)1

This book argues that those with economic “might” subverted law and regulation in the years leading up to the financial meltdown of the fall of 2008. They rigged law to loot the American economy with impunity.2 Between 1986 and 2008, constraints on economic power ranging from liability under the federal securities laws to the duty of care for directors of public firms to the limits on the size of financial institutions vanished, freeing corporate and financial elites to pocket huge windfalls for economically pernicious misconduct. Further, new activities and frameworks fundamentally left elites with the power to impose massive costs upon society in general while reaping huge paydays, ranging from the nonregulation of derivatives to the construction of our globalized economy. The law unleashed the powerful to prey upon the disempowered through predatory mortgage lending. When the collapse came, the government bailed out the reckless, proving the lack of accountability under law. Today, the same elites remain at the pinnacle of our economy, where they continue to collect record bonuses. Indeed, in December 2010, our politicians extended tax cuts for these elites.3 184

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All of this legal indulgence, at variance with tradition and policy, occurred as historically high economic inequality took hold in the U.S. Corporate elites leveraged their new-found economic power to seize more power over the commanding heights of our capitalist system—the public corporation. Shortly thereafter, they seized the commanding heights of the commanding heights—the largest financial firms in the U.S. Now, a few dozen CEOs hold the reigns of economic power in the U.S., including those of economic regulation and law.4 The Dodd-Frank Act leaves those in control of the financial sector undisturbed. The recent Supreme Court decision in Citizens United v. Federal Election Commission promises to further concentrate power in these very few hands.5 The “triple whammy” of concentrated economic power—income inequality, the concentration of CEO power over the public firm, and the concentration of power within the financial sector—created an unprecedented concentration of economic power in very few hands. As predicted by economists and political scientists, the breakdown of law and regulation followed shortly thereafter. Then, capitalism nearly collapsed in the U.S. and globally.6 Simply put, the closest flirtation with total financial collapse followed the highest degree of economic concentration in our history.7 Today, that concentration of economic power continues unabated and threatens further economic pain. The Dodd-Frank Act suggests that notwithstanding further financial crises and economic disruptions, governing elites will steadfastly resume their flirtation with and indulgence of concentrated economic power. This all stands at great variance with American economic and legal history, as well as traditional American suspicion of concentrated power as manifest in our Constitution, which effectively diffuses political power among three co-equal branches and among dual state and federal sovereigns.8 In fact, American history stands as a monument to John Stuart Mill’s insight that all human progress finds its roots in power constrained by law. Consider the New Deal. It imposed unprecedented accountability upon power. It broke up J. P. Morgan’s megabank.9 It imposed for the first time broad disclosure obligations and liability upon corporate and financial elites. It empowered workers and more than doubled the number of college graduates between 1940 and 1950.10 Never before did the American legal system so dramatically transform economic and political power in America, and seventy years of prosperity followed.11 Only when elites exploited fading memories and the power of race in America (most notably in 1980 with the election of Ronald Reagan and the perfection of the so-called Southern Strategy) did the New Deal fail and did economic power reach pre-Depression levels

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legislators, or that it is dangerous to them because a competing class has gained in power, or that it transcends the limits of self-preference, which are imposed by sympathy.” All that law can do is to “modify itself in accordance with the will of the de facto supreme power in the land.” Holmes essentially viewed law as a zero sum game between competing economic classes, and therefore he maintained that law simply acted as an instrument of class domination.17 Holmes’s endorsement of class warfare through law presents a myriad of problems. First, the Holmes approach to law drips with cynical dishonesty. It directly contradicts the rhetoric and ideals of the law. Indeed, the ultimate monument to the American legal system, the U.S. Supreme Court building, promises every citizen “Equal Justice under Law.”18 This basic principle of American law itself can find its roots in the teachings of the Greek orator Pericles that Greek law knows no “class considerations” or any “bar” based upon poverty.19 Ours is “a government of laws, and not of men.”20 Holmes’s vision promotes law as a power play, with lawmakers constantly taking measure of each participant’s economic firepower so that they can know which class to favor in the contest. Law schools do not teach this mode of legal reasoning, judges do not clothe their decisions on these grounds, and politicians do not run for office on the promise of identifying the most powerful and fostering their entrenchment. Thus, this vision of law devolves quickly into survival of the most treacherous, not the “fittest.” This view of the law is nothing short of rule by fraud instead of law. If law operates to promote only the interests of the most politically or economically powerful, then the rhetoric of the law must change. Otherwise, it becomes impossible to identify the “fittest” as opposed to the most entrenched and the most sinister. Only a level economic arena can identify the “fittest.” Second, as shown throughout these pages, the subversion of legal and regulatory infrastructure for profit, the exploitation of the disempowered, the festering of class privilege and class disadvantages, and the neglect of economically rational human capital development and market development are not zero sum games but deeply negative sum realities for the entire economy. In short, Holmes’s views entail an economic catastrophe. Modern economics teaches that growth follows legal institutions that operate directly opposite of the Holmes vision. As the economist Daron Acemoglu highlights, growth requires “good institutions” that are marked by “constraints on the action of elites,” including “property rights for a broad cross section of society” and “some degree of equal opportunity for broad segments of society.”21 Human capital formation, regulatory infrastructure, and market development must be secured by the rule of law, if macroeconomic considerations form a goal of

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operating as an instrument of elite interest to the detriment of the commonweal. In short, Hayek’s vision of rule by law fails to secure macroeconomic growth and stability. Although Hayek moves beyond the thinnest rule of law, his vision is still consistent with feudalism, genocide, and mass disempowerment. Hayek and Holmes both countenance a rule of law consistent with the vast weight of state-sponsored oppression, even genocide, seen throughout human history. This vision of the rule of law proves both economically and morally bankrupt. The Chinese legal scholar Li Shuguang argues for a rule of law that curbs the abuse of power and suggests that the rule of law should be distinguished from the rule by law in that the rule by law permits “the law [to] serve as a mere tool that suppresses in a legalistic fashion.”27 In the economic sphere, this vision of the rule of law should operate to limit opportunities for irrational deviations from accountability for the violation of traditional market norms. It should also operate to limit severe power imbalances that prove macroeconomically corrosive and morally objectionable. Such an economic rule of law would impose accountability in a way that is not democratically negotiable, and it should operate to curb the abuse of economic power to harm human capital development. This vision of minimal levels of accountability inspires popular support by holding even the most powerful to account. It limits the ability of concentrated economic interests to abuse power by disempowering or exploiting others. Professor Tamanaha argues in favor of a less expansive rule of law. Tamanaha recognizes that the rule of law cannot function in a society that pervasively questions the even-handedness of the legal system. Without a firm belief in the fairness of the law, citizens will disregard the law when opportunities to flout the law present themselves. This in turn corrodes the ability of the rule of law to rule. Thus, the rule of law requires that citizens believe in the rule of law, and this perception will not hold if the law suffers from widespread bias in application.28 Presumably, under this approach law tolerates economic abuses under law so long as the mass of people continue to adhere to the rule of law because they believe in the rule of law. Thus, the Jim Crow South may persist as an exemplar of the rule of law so long as its citizens firmly believe in the fairness of the legal system. The “thickest” vision of the rule of law emerged from an international gathering in New Delhi in 1959 of more than 185 judges, lawyers, and law professors from 53 countries. At its “thickest,” the Rule of Law is a dynamic concept for the expansion and fulfillment of which jurists are primarily responsible and which should be employed

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the economic death of impoverishment. This more demanding rule of law would yield great economic benefits in terms of growth and stability even beyond averting crises.32 Economists know that the rule of law plays a crucial role in macroeconomic performance. Yet they admit to failing to define the rule of law.33 The Nobel laureate Robert Lucas, a pioneer of the study of economic growth, along with others previously mentioned, holds that no other economic issues rivals growth in terms of its potential impact on human welfare. As previously shown, growth means more resources to meet challenges such as global warming, environmental degradation, starvation, infant mortality, and disease. Because the keys to growth involve human capital formation, market development, and economically rationalized legal and regulatory infrastructure, the path to maximum growth fundamentally runs through an optimal rule of law that constrains elite action to impair growth for their own benefit. History and economics prove that these elements of growth cannot take hold unless secured by law. The increasing attraction of economists to growth becomes easy to understand once one ponders the stakes for humanity. The value of growth should drive visions of an economic rule of law because otherwise those with power may use the law to irrationally impose massive costs on all others. In the end, this vision of an economic rule of law secures the same values as a political rule of law: individual autonomy, integrity, and freedom. The neglect of these values led to exploitation and economic catastrophe at the same time during the subprime debacle.34 These failures of law to stem the abuse of power and economic despotism cost trillions. The cost of the resulting financial crisis of 2007–9 may not be known with certainty for years to come, but it will certainly amount to trillions of dollars in financial losses and forgone economic growth, as well as massive government expenditures and bailouts. Since the end of 2008, U.S. debt increased by trillions as the government strove mightily to save the financial sector and revive the economy.35 Globally this failure of law led to trillions in additional debt across the world, threatening another, more dangerous crisis arising from sovereign debt defaults.36 A more robust economic rule of law can prevent such crises by limiting the ability of governing elites to subvert legal and regulatory infrastructure, exploit the disempowered, and neglect market development through the maintenance of a broad middle class. The U.S. remains far from this vision of an economic rule of law. Abundant evidence proves that the U.S. economy suffers from a second-rate legal system akin to that of Third World countries. Our economic system suffers from corporate and financial elites untethered to legal accountability and

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wrongdoing.48 Financial elites cognitively and culturally captured the Obama White House.49 The savings and loan crisis of the 1980s spawned nearly 1,000 felony convictions.50 Given the massive costs imposed by this crisis, only a failure of law explains such a failure of justice. As one commentator stated in mid-2010, “[T]he American people should now get the justice we deserve, in the form of prosecuting the people on Wall Street who had major roles in causing the financial crisis in the first place.”51 Simple accountability disintegrated in this crisis, and restoring the rule of law to finance will require criminal convictions of those responsible for the lawlessness in our banks.52 This historic pacification of criminal accountability will dilute disincentives for criminal profits for decades to come. But the lack of criminal accountability forms just one element of the breakdown in law.53 The bailouts effectively socialized losses while privatizing profits. This amounts to an unprecedented betrayal of capitalism.54 The former Chief Economist of the IMF Simon Johnson called the bank bailouts “the Quiet Coup,” because the bailouts as structured deviated so dramatically from the best economic science regarding assistance to the financial sector.55 I argued that the bailouts inexplicably left the errant (perhaps even corrupt) financial elites at the helm of the financial sector and therefore extended windfalls to the least meritorious based only upon political power. All of the bailouts fail even the Hayek version of the rule of law because the bailouts did not arise from fixed rules announced in advance.56 The revelation of lawlessness within the financial sector reached new heights in late 2010, when the foreclosure crisis demonstrated that financial and corporate elites not only acted recklessly in underwriting and packaging subprime mortgage-backed securities but also acted recklessly in documenting their mortgage rights. One court characterized the banks’ misconduct as “utter carelessness.”57 For example, the banks filed massive numbers of fraudulent affidavits in support of foreclosure, apparently expecting impunity.58 Further, the banks filed mortgages with recorders’ offices across the nation that named fictitious mortgagees to evade the need to record the actual beneficial owners and incur additional transaction costs in the form of filing fees.59 Finally, the banks failed to ensure the proper transfer of promissory notes under the law of commercial paper.60 All of this created unprecedented uncertainty in American property rights, prompting experts to predict an even more extended recession.61 Economists quickly held this fiasco up as an example of the deterioration of the economic rule of law in America.62 Earlier, other signals suggested the rule of law needed reinvigoration in the U.S. A recent global assessment of the rule of law co-sponsored by the American Bar Association found that the U.S. ranked near the bottom among

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fear that they will suffer noncompensable losses. A compromised rule of law can impair investment in particular and destroy an economy. The rule of law should operate to move society toward the expanded theoretical model of perfect competition I articulated earlier—a model that recognizes the macroeconomic toll of disempowerment and privilege. The failure of the rule of law to control concentrated economic power will entail economic costs, including the likelihood of severe financial crises as elites erode important regulatory and legal infrastructure for their own profit and neglect important props to stable growth. In short, law, policy, regulation, and politics must view large concentrations of economic power with suspicion. Laws that favor the powerful must suffer a presumption of illegitimacy and laws in favor of the disempowered must enjoy a presumption of political approval, as Adam Smith suggested long ago. Such a rule of law will support both macroeconomic growth as well as a more robust humanity by securing both the durability and quality of life in terms of life expectancy, educational attainment, creativity, and prosperity. The Basic Contours of the Economic Rule of Law The concept of an economic constitution or an economic rule of law revolves around the principle of political non-negotiability and insulation. Political non-negotiability always involves a broad consensus that the law should protect core values against mere transitory political goals. Constitutional values form the paradigm of political non-negotiability to the extent that constitutional rights enjoy protection from political infringement. Since the New Deal, monetary policy operated largely free of political interference because of the political structure of the Fed. Certain other issues, such as civil liability, evolve under the auspices of the judiciary, long considered the least democratic branch of government, and consequently enjoy some degree of political insulation. Similarly, professional associations historically regulate important economic functions free of excessive political influence. The protection of these core economic values helped the U.S. develop economically, particularly in the decades following World War II. This chapter assesses the means and likelihood that the U.S. could continue this leadership, which will necessarily require an expansion of the core economic values removed from the political arena through law. Constitutional Protections Values secured under constitutional principles typically rely upon judicial review for protection. Judicial review requires judges—and ultimately

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sufficient resources to compete and contribute economically. This necessarily diminishes the burdens of privilege. If the Constitution protected basic rights to adequate education, universal health care, and decent housing, excessive concentrations of wealth would not do as much economic harm.81 A welleducated populace could check elite political power at the polls. Empowered citizens do not fall prey to elite overreaching as U.S. citizens did during the subprime debacle. Unfortunately, neither the courts nor legal elites in the U.S. see fit to pursue this vision of human rights even though other nations, such as South Africa, do judicially enforce such rights.82 In the recent past, the U.S. Supreme Court appeared inclined to move in this direction, but political shifts short-circuited the recognition of any positive rights.83 Constitutionally recognized economic human rights could operate to mitigate economic power imbalances and may diminish the likelihood of another financial crisis rooted in legal subversion and predation. The current majority in control of the Supreme Court, however, appears intent upon maintaining the current economic status quo. Depoliticizing Regulatory Agencies Law can secure core values without express constitutional provisions. Thus, for example, the Federal Reserve Board’s administration of monetary policy exemplifies depoliticized regulation and the potential for a hardened regulatory agency that can resist the influence of the regulated. The SEC, on the other hand, illustrates the paradigm of a captured regulatory agency. As Harry Markopolos puts it, “The SEC  .  .  . has suffered through decades of sloth, abysmal leadership, underfunding and benign neglect.”84 While this section focuses upon the Fed and the SEC, the core point, that institutional design matters in terms of resisting the efforts of growth-retarding elites to subvert regulatory infrastructure, could well apply to each regulatory agency responsible for financial regulation. Overall, the regulatory state failed in the U.S., even though sound regulation must guide the economy, as it successfully did for several decades after the New Deal.85 The Federal Reserve Board enjoys the highest degree of political insulation for purposes of monetary policy. Congress endowed the Fed with a selffunding mechanism (levies on member banks), which means that Congress does not control its purse strings. Members of the Federal Reserve Board, the ultimate governing authority within the Federal Reserve System, serve for fourteen years. The Fed also pays relatively high salaries for government agencies. It need not concern itself with regulatory competition as it is the sole authority with respect to monetary policy. All of this gives the Fed the

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proportions right under its regulatory nose.97 With respect to subprime mortgage-backed securities, the SEC admitted that it practically never reviewed prospectuses and offering materials.98 Indeed, in the face of a financial scandal featuring widespread securities fraud, the SEC filed no enforcement actions against any major issuer or seller of mortgage-backed securities until after the crisis even though the FCIC found indicia of securities fraud.99 Further, according to the SEC’s own Inspector General, the SEC knowingly allowed the nation’s largest investment banks to gorge on debt and take huge risks on board, and it took no regulatory action.100 Thus, this key regulatory agency, like the Fed, botched its regulatory duties in a way that facilitated key elements of the crisis. Even prior to the subprime crisis, powerful evidence proved that the SEC could not resist corporate influence.101 Indeed, former SEC Chair Arthur Levitt wrote an entire book cataloging his efforts to impose sound regulation in the face of determined and well-heeled corporate and financial interests.102 Business luminaries like Enron CEO Ken Lay lobbied to stop the SEC from enhancing auditor independence—and ultimately Enron crashed in an accounting storm that showed the mythological nature of auditor independence. Congress eagerly supported business interests over the efforts of the SEC.103 During the battle with corporate America over the PSLRA, senators threatened to “turn off the lights” at the SEC if it did not support corporate interests.104 For decades, politicians held SEC funding hostage to special interests, and influential voices advocated self-funding.105 According to Levitt, one problem (which would be predicted by Mancur Olson’s Theory of Collective Action) is that investors simply lack a lobbying organization that can compete with corporate wealth.106 Furthermore, the SEC long suffered from a regulatory revolving door that too often caused staffers to work hard not to “rock the boat” in the very industry in which they may ultimately seek employment.107 Regulatory competition also plagues U.S. financial regulation. Financial firms hold discretion to pick their regulator to a significant degree. This means that regulators cannot assume a stricter posture than competing agencies without facing the risk of regulatory migration. For example, Countrywide Financial switched from a bank charter to a thrift charter, effectively trading the OCC and the Fed for the OTS as its primary regulator. The OTS actually recruited Countrywide. Countrywide told public investors that it sought a more housing-focused regulator. Internal memoranda show that Countrywide thought the OTS would conduct fewer and less intrusive examinations and generally lacked sophistication. The OTS promised to permit pay-option mortgages, which the Fed resisted, while the OCC took a stricter view of

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profession. Dean of Harvard Law School Roscoe Pound posited that professionals as a group “pursu[e] a learned art as a common calling in the spirit of public service, its work no less a public service because it is also a means of a livelihood.”112 Ideally, “professions, if sufficiently free and independent, provide individual citizens with a buffer against authoritarian and overreaching governmental power.”113 The creation of professional mandates, supervised through an appropriately supervised self-regulatory organization, forces professionals to subordinate self-serving, short-term needs to the possibility of disbarment. High standards of professional conduct can lead to higher client trust and higher profits. Professionals as a group thus become vested in maintaining high standards to preserve the pricing power that trust may inspire. Once a profession is created, a built-in constituency seeks its preservation, and the dilution of professional standards can become politically difficult. Professionalization regimens rely upon an important subset of regulatory tools to enforce economic norms. For example, stockbrokers must adhere to broad professional regulation, backed by the coercive powers of the federal government. They must pass qualification exams, register with the SEC, adhere to a professional code of conduct, and face professional discipline. Sanctions for violations of professional conduct standards can result in fines, suspensions, and even expulsion from the industry. Stockbroker misconduct played a role in the Great Depression. In the nearly eighty years since the advent of professionalization of the securities business, broker misconduct in regulated markets has never again figured in a financial disruption.114 Politics rarely intrudes in this professional regulation. Similarly, common law tort liability—including professional malpractice, fraud, and negligent misrepresentation—traditionally imposed broad norms of professional accountability under the expertise of the judiciary. These norms applied to all professional actors regardless of political connections. Professional malpractice requires the testimony of a peer professional. This gives the professions the ability to police themselves as an additional form of self-regulation.115 This privilege of self-regulation and enhanced protection from liability compensates for the need to adhere to professional competence and ethics. The subprime fiasco cries out for expanded professionalism. Mortgage brokers made loans that can only be termed predatory for borrowers and suicidal for the financial system.116 CEOs and boards took on risks that put either their competence or their ethics at issue.117 Credit rating agencies faced no incentive for rating securities other than in accordance with their own profit motives and with no penalty for ineptitude.118 In a highly interdependent economy, where one person’s ineptitude leads to another person’s

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our key leaders. Insisting upon national service certainly provides a forum for testing individual merit and can thereby help restore the American meritocracy that seems ever more mythological.122 The subprime crisis impugns the quality of American leadership and calls the very nature of our so-called meritocracy into question.123 In exchange for such a service requirement, upon honorable discharge each youth could be entitled to a four-year college education at an institution of his or her choice. Currently there is no universal service requirement, and too many of our youth face incarceration rather than service with the promise of education. The key point, economically, is that every child could attain a college education at no cost—much like the GI Bill in place after World War II. This would diminish inequality, develop our human resources, and eliminate the type of deep disempowerment that drove the predatory lending underlying the subprime debacle. Solid empirical evidence demonstrates that such a program would pay for itself, as the GI Bill yielded up to $12.50 for each dollar expended.124 In a nation in which one in four children languishes in poverty, this kind of entitlement program could empower millions in potential competitors to reduce the sway of privilege in our economy and move toward a more perfect competition.125 Once a broad percentage of Americans serve, it would be politically challenging to substantially reduce funding for their educational entitlement. Securing Accountability through Civil Liability While the New Deal used experimentation as the basis for many of its innovations, it also relied upon “ancient” principles of accountability to restore faith in the financial system.126 The pre–New Deal securities markets made little sense economically. Corporations owed no obligation to provide any information to their shareholders. Without basic information, America’s securities markets resembled a casino more than a crucial mechanism for the allocation of capital. As John Maynard Keynes put it, “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”127 Investors understandably lack confidence in securities if they lack basic information regarding their investments. This creates markets prone to panic. Any sound vision of capitalism includes the free flow of reliable information. The New Deal responded to this bizarre form of capitalism with a mandatory-disclosure regimen providing for the periodic dissemination to shareholders of all material information regarding a firm, accompanied by broad investor remedies. Chapter 2 reviewed evidence of the economic

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cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets.”136 The Court seemed oblivious to the possibility that the destruction of shareholder rights is not costless and will operate to raise the cost of capital. Even shareholders with no desire ever to file a claim may perceive that our securities markets lack fairness. Diminished investor confidence entails a higher cost of capital. Justice Kennedy’s approach seems destined to shrink American capital markets, as the best economic evidence available suggests that “both extensive disclosure requirements and standards of liability facilitating investor recovery of losses are associated with larger stock markets.”137 Aiding and abetting liability required corporate gatekeepers—accountants, attorneys, and other consultants—to ensure truthful disclosures in accordance with “several hundred years” of common law precedent. Thanks to the Supreme Court’s dilution of accountability, investors in U.S. stocks should expect more fraud.138 The ultimate irony of Justice Kennedy’s rhetoric is that it immediately preceded a historic meltdown in the American financial sector related to subprime mortgage securities that operated to destroy global confidence in the honesty of American financial markets. Second, Congress should repeal the Private Securities Litigation Reform Act of 1995. That Act extended special protections unknown in common law to securities fraudfeasors. Securities fraudfeasors do not deserve special protections; instead, securities fraud should carry enhanced sanctions because of the key role that securities markets play in economic growth and stability. No policy supports encouraging fraud in the nation’s securities markets through indulgent law. At the very least, Congress should repeal the provision imposing enhanced pleading requirements for scienter (prior to discovery) and the safe harbor for forward-looking frauds. Since 1995, scandals have become endemic in the securities markets. The Internet bubble, the options-backdating scandals, and the subprime mortgage crisis all counsel against laws protecting those who commit securities fraud. The essential problem is that legal elites began to believe that the securities laws “may be a waste of time.” Since 1975, the Supreme Court has relentlessly narrowed the scope of private rights of action under the federal securities laws, contending that “that litigation under Rule 10b-5 presents a danger of vexatiousness different in degree and in kind from that which accompanies litigation in general.”139 This refrain appears again and again in the Court’s rulings on private securities fraud claims.140 The Court’s current attitude represents a dramatic departure from the approach of justices with a less remote acquaintance with the reality of the Great Depression. Prior to 1975, the Supreme Court sought to interpret the federal securities laws to achieve

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the SEC never pursued similar misconduct on a large-scale basis. Elite subversion of regulatory agencies means that private actions must play an essential role in deterring misconduct.154 Private actions could serve to deter future instances of manifestly deceptive practices on such a systematic basis, with such devastating macroeconomic consequences.155 Fraud, negligent misrepresentation, breach of fiduciary duty, professional malpractice, and the duty of good faith and fair dealing must robustly operate to ensure appropriate market incentives and accountability. Private civil claims hold a key advantage over law enforcement claims. Private plaintiffs’ attorneys do not typically run for office, do not solicit campaign contributions, and would face disbarment if they ever accepted any side payment from a defendant they pursued. Private attorneys face incentives for aggressive pursuit of claims in the form of large contingency fees that may be earned if a case results in a large recovery. Further, private claims do not require government expenditures, and tight budgets do not reduce the number of private attorneys prepared to pursue civil claims. Thus, a society that takes accountability seriously will provide for generous private claims in accordance with common law notions of responsibility. Indeed, this is a traditional mechanism by which capitalism protects property rights of all—even Ayn Rand, the legendary libertarian, condemned fraud.156 The real question is why the Supreme Court (and Congress) seems so eager to make securities fraud profitable.157 Securities fraud covers the full breadth of the financial sector, and beyond; thus, the diminution of this source of accountability will plague our entire economy for years. The crisis arose from a breakdown in accountability and ethics.158 Our business system and our entire economy rely upon trust. People will not invest if they face a substantial risk of a fleecing. Law must secure transparency, good faith and fair dealing, accountability, and responsibility. Even the most powerful financial elites must face legal sanction for the kind of misconduct that drove every phase of this historic crisis.159 The failure of law to restore historic norms of accountability in the name of indulging elite power will ruin the American economy and sentence our children to life in a Third World economy. Restoring Legal Accountability and Suspicion of Concentrated Power The Great Depression rocked the foundations of the American economy and American society. Unemployment soared to 25 percent and output dropped by 33 percent. This means that the Great Depression inflicted economic pain to a much greater extent than the crisis of 2007–9 when unemployment

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argued that fundamental reforms—like Brown v. Board of Education—result from the convergence of interests between elites and the disempowered. That convergence arose in terms of civil rights from the competition between the U.S. and the Soviet Union for the hearts and minds of people of color around the world. Segregation blighted American claims to liberty and freedom.163 The Bell theory of interest convergence now enjoys broad support both empirically and from the development of similar theories in economics and political science.164 Richard Delgado extends Bell’s insight to argue that marshaling elite support paves the way for reform.165 Usually this convergence arises from crisis conditions that generate fear among those with economic and political power. Thus, for example, the fear of communism and the need for the U.S. to project itself as a just society in Africa, South America, and Asia played a key role in the outcome of Brown v. Board of Education, as Professor Bell predicted.166 The GI Bill, which helped double the number of college graduates between 1940 and 1950, arose from the fear that 16 million returning war veterans would trigger mass unemployment, a possible depression, and social unrest, as occurred after the wind-down from World War I.167 When the Soviets launched their Sputnik satellite in 1957, a shocked U.S. prompted the Eisenhower administration to counter the threat of Soviet technological superiority with a massive federal investment in science education, as well as the creation of a new agency to coordinate scientific research (ultimately leading to the creation of the Internet).168 The Marshall Plan sprang from the possibility of widespread economic strife in Europe and fear of Soviet-style states taking root there, a prospect it quelled by assuring the creation of prosperous mixed economies founded upon markets.169 Major economic reforms or development initiatives require a crisis to generate the fear needed to bring otherwise entrenched elites to the table to negotiate for broad-based growth efforts. International competition may serve to bring out the best in American capitalism. In fact, since the end of the Cold War no similar effort of the same scale as the massive investments discussed here occurred. The nation that constantly strives to perfect its economic rule of law will achieve superior macroeconomic performance. Global competition to optimize legal and regulatory infrastructure should create pressure for constant improvements in law. The American brand of capitalism overcame these pressures and imposed a neoclassical regimen upon the world economy, seemingly rigging the process in favor of laissez-faire outcomes. This constipated the development of the economic rule of law worldwide. Fast-growing nations, such as China, ignored the insistence upon laissez-faire, opting instead for a highly interventionist approach.170 By definition, laissez-faire

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of financial regulatory issues from “too big to fail” to derivatives regulation to the shadow banking system. Education could nevertheless mitigate the impact of elite domination of the economy. Certainly, in general, a college graduate likely could fully understand these issues with greater ease than a person with only an eighth-grade education. Thus, mass higher education may well serve to create additional pressure for reform and for a rationalized economic rule of law. Indeed, it may well be time to expand mandatory education beyond age sixteen. Another means of enhancing the prospects for a durable economic rule of law would be enhanced primary and secondary education in the specific areas of economics and business. The U.S. benefits from a sophisticated capitalist economy. Informed capitalist participation should constitute a fundamental value in such an economy. Capitalism works best when informed decision makers make intelligent economic choices. Much evidence suggests that in the world’s largest capitalist economy, many citizens simply lack the necessary understanding to participate in the economy constructively.178 In the subprime debacle, unsophisticated borrowers suffered from deep exploitation by sophisticated lenders. In short, uninformed traders in a capitalist system can impose broad societal costs.179 Therefore, the already strong case for enhanced financial and economic education efforts now enjoys overwhelming support.180 Finally, legal academics must train tomorrow’s leaders to appreciate the role of law and regulation in securing conditions conducive to growth. Today, our leadership suffers from delusions about self-correcting markets that are deeply rooted in our culture. The default reaction of our governing elites still tends toward the approach of virtually all Law and Economics texts—laissez-faire efficiency. Our judges similarly harbor misconceptions about economic growth like the misguided conclusions of Justice Kennedy regarding how law fosters enhanced capital market development. The fact that his rhetorical position goes unchallenged in the Supreme Court stands as testament to the flawed approach of the legal academy to the intersection of Law and Economics. Laissez-faire lives on among legal elites in the U.S. despite overwhelming evidence that it remains an economic dead end, just as it was proven to be in the Great Depression. The hope is that Judge Richard Posner’s epiphany regarding the need for regulation constitutes the first step in a reconfiguration of Law and Economics to include evidence regarding the relationship of law and regulation to growth and stability.181 America needs to adjust its economic constitution—that is, the laws, regulations, and cultural frameworks that govern economic activity. The U.S. is uniquely suited to this effort because of its political and economic history.

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There are other flaws with Dodd-Frank, many discussed in earlier chapters. Dodd-Frank leaves the SEC’s institutional structure unchanged, despite its sordid record manifest failures with respect to the subprime debacle. The current SEC Chair, Mary Schapiro, argued for a self-funding mechanism for the SEC.183 The Fed similarly continues with the same institutional structure that failed the nation. Indeed, Dodd-Frank, as shown previously, gives the Fed even more power. Thus, a regulator with a manifestly flawed institutional structure now has more power. This invites further crises. The Act does nothing to change the incentives facing senior managers of public firms in a meaningful way or in a meaningful time frame.184 The Act does nothing to disrupt a global economy that elites rigged in their favor and operates to burden the U.S. with ever more debt without regard to adverse economic consequences.185 Dodd-Frank allows the megabanks to continue to gamble in the derivatives and securities markets far into the future.186 In short, the Act will prove ineffective in stemming the next financial crisis. Fundamentally, this outcome arises from the Dodd-Frank Act’s determined effort to do as little as possible to alter the current distribution of economic and political power. More specifically, it leaves a handful of large banks and corporations largely in the hands of a few men with even more political and economic power that they held prior to the crisis. Under this reality, one outcome remains certain: These corporate and financial elites will continue relentlessly to subvert regulatory and legal infrastructure in their favor. The Dodd-Frank Act suggests that Americans still harbor odd delusions regarding their economy. Many seem more threatened by the economically weak than by the very powerful—a rather backward outlook on reality. The powerless by definition cannot harm society as much as the powerful. Rather than demand that government hold economic power to account, in the election of 2010 voters seemed determined to disempower government to impose rational regulation. The most noteworthy outcome of this bizarre turn is that the American people demanded that political elites cut the taxes of their friends, the corporate and financial elites at the center of the crisis, leaving ordinary Americans facing a fiscal nightmare.187 The extension of the Bush tax cuts in early 2011, with broad bipartisan support, even for the very wealthiest in our society, strongly demonstrates that the deep economic crisis that took root in the fall of 2008 created insufficient pain for the body politic to muster the will to constrain the economic power of corporate and financial elites. Simply put, they crashed global capitalism, and the politicians cut their taxes. The reform energy that so influenced the election of 2008 had completely dissipated by 2010.188

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review arbitration decisions, employees win only 32.1 percent of the appeals; when appointed or nonpartisan elected judges decide such cases, employees win 52.7 percent of the time.196 Studies long ago demonstrated that campaign spending (especially television advertising) enhances the chances of victory in legislative elections.197 Economists recently developed more sophisticated models to focus on the effectiveness of campaign contributions in influencing legislative behavior that demonstrates the expected outcome: Money influences legislators and thus law.198 The passage of the TARP bailout bill proves that special interests may purchase even unpopular legislation.199 Thus, “[s] eating judges that are hostile to workers and cozy to corporate interests will surely be a byproduct of Citizens United” and “[e]lecting legislators that are passionate laissez-faire capitalists and antagonistic toward common sense corporate regulation will surely be a byproduct of Citizens United, despite a clear failure of capitalism in the recent financial market crisis.”200 Professor Hasen suggests that “supporters of campaign finance reform may have to wait another generation and [for] a change in Supreme Court personnel for the opportunity to overturn Citizens United.”201 I disagree. While the Citizens United case will certainly operate to entrench the very corporate and financial elites who lie at the core of the entire financial crisis of 2001–9, it also lays the foundation for another crisis arising from America’s second-rate economic rule of law. Dodd-Frank and Citizens United take America into economically uncharted waters and raise an urgent question: How much economic pain can hyper-concentrated economic power untethered to the rule of law cause? My supposition is that a massive economic crisis will prompt the American body politic to denude corporate and financial elites of their unmerited and pernicious control of our economy and lead to a massive realignment in the distribution of economic and political power on a scale beyond the New Deal. Noted jurists recognize that adherence to the principles of Holmes led our legal system into “the embarrassing valuelessness in which American jurisprudential theory finds itself wallowing today.”202 The vision of an economic rule of law offered herein seeks to replace this valuelessness in law with a new value that focuses upon maximum and broadly distributed economic empowerment of individuals by resisting privilege. Such empowerment will maximize the resources available to society to secure a more robust humanity in terms of life expectancy, educational attainment, health outcomes, prosperity, creativity, and environmental sustainability. In short, this vision of maximal empowerment maximizes the excellence of life. Under this approach, law must inveigh against high inequality that undermines individual empowerment or spawns privilege and thus compromises growth,

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economy would be more free of the costs and risks of substantial financial disruptions. Given the costs of the subprime debacle, this too is likely a multi-trillion-dollar issue. These issues are just a few ways that law can enhance innovation and therefore growth. An optimized rule of law would unlock tremendous economic growth and pave the way to any kind of post-scarcity world. Such a world begins with maximum human empowerment. Indeed, it is difficult to imagine any other way to achieve the highest possible economic growth. People and ideas certainly play a central role in economic growth. Allowing all people to compete to achieve their highest and best use should axiomatically form the core function of an economic rule of law. Privilege and disempowerment corrode human incentives to compete. Privilege also threatens law. Those holding concentrated economic resources will naturally seek to entrench their power through subverted law and regulation. This will operate to create uneven playing fields. Thus, law should inveigh against excessive privilege and disempowerment. Law should similarly inveigh against elite power to subvert legal and regulatory infrastructure. Achieving optimal human capital development, optimal market development, and optimal legal and regulatory infrastructure law operates to maximize economic growth. It also creates the shortest path to a postscarcity world. Even a cursory scan around the world reveals massive economic potential locked into idle or near-idle resources. American banks, in fear of their own insolvency, hoard $1.5 trillion in excess reserves.10 America’s corporations, in fear of another credit collapse, hoard another $2 trillion.11 Emerging nations hold more than $10 trillion in currency reserves.12 These reserves operate to fund excess consumption and dangerous debt levels in the entire developed world.13 On the human side, 2.6 billion souls subsist on less than two dollars per day. The awesome scale of wasted resources across the world proves the costs of allowing elites to lawlessly run riot across the global economy. A new cultural abhorrence of wasted economic potential must take root. People should abhor the mass disempowerment of people because it necessarily means that all humans suffer economically from wasted and underutilized economic resources. Optimized legal infrastructure with optimized incentives for all would minimize economic waste. Ultimately, a suboptimal economic rule of law takes a huge, almost unimaginable economic toll on everyone, relative to a world with a sound economic rule of law.

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Notes

Preface 1. Andrew Jackson, Bank Veto Message to the Senate (July 10, 1832), reprinted in 2 A Compilation of the Messages and Papers of the Presidents 576, 590 (James D. Richardson ed., 1897). 2. Andrew Ross Sorkin, Too Big to Fail 2, 3 (2009). 3. Id. at 401 and 409–10. 4. Simon Johnson and James Kwak, 13 Bankers 165 (2010). 5. Steven A. Ramirez, Subprime Bailouts and the Predator State, 35 Dayton L. Rev. 81, 87 (2009) (citing Joe Nocera, As Credit Crisis Spiraled, Alarm Led to Action, N.Y. Times, Oct. 1, 2008, at A1 (quoting Federal Reserve Chairman Ben Bernanke) and Frontline: Inside the Meltdown (PBS television broadcast, Feb. 17, 2009), available at http:// www.pbs.org/wgbh/ pages/frontline/meltdown/etc/synopsis.html). 6. Emergency Economic Stabilization Act of 2008, Pub. L. No. 110–343, 122 Stat. 3765 (2008) (codified in scattered sections of 12, 15, 26, and 31 U.S.C.). 7. Ramirez, supra note 5, at 86–90. See also Thomas Ferguson and Robert Johnson, Too Big to Bail: The “Paulson Put,” Presidential Politics, and the Global Financial Meltdown, 38 Int’l J. Pol. Econ. 3, 25–27 (2009) (discussing Secretary Paulson’s efforts to pursue a “shadow bailout” outside of public view by directing the Federal Home Loan Banks (a lender of last resort for thrifts), Fannie Mae, and Freddie Mac to purchase mortgages from banks and thrifts). 8. Gretchen Morgenson, The Rescue That Missed Main Street, N.Y. Times, Aug. 28, 2011, at BU1. 9. Ramirez, supra note 5, at 86–90. Ultimately, the government essentially socialized the mortgage market and directly funded nearly all mortgages through its wards Fannie Mae and Freddie Mac. Zachary A. Goldfarb & Dina El Boghdady, Mortgage Market Bound by Major U.S. Role, Wash. Post, Sept. 7, 2009, at A01 (noting that 90 percent of all home mortgages were funded or guaranteed by the government, including Fannie Mae and Freddie Mac). 10. American Recovery and Reinvestment Act of 2009, Pub. L. No. 111–15, §§ 1101, 1302, 123 Stat. 115 (2009). 11. Sorkin, supra note 2, at 440. 12. John C. Dugan, Comptroller of the Currency, Remarks before the Exchequer Club, at 6 (Jul. 21, 2010), available at http://www.occ.gov/news-issuances/speeches/2010/pubspeech-2010-84a.pdf (stating that “the recent financial crisis was caused by a number of factors [including] at the heart of it all, the worst mortgage underwriting in our nation’s history”). 13. Roger Lowenstein, The End of Wall Street 18 (2010). 14. David Reilly, U.S. Banks Get Boxed in on Foreclosures, Wall St. J., Oct. 9–10, 2010, at B16.

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41. Lucian Bebchuk et al., The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000–2008, 27 Yale J. Reg. 257, 259 (2010). 42. Aaron Luchetti and Stephen Grocer, On Street, Pay Vaults to Record Altitude, WSJ.com, Feb. 2, 2011, http://online.wsj.com/article/SB10001424052748704124504576118421859347048.html; Liz Rappaport et al., Wall Street Pay: A Record $144 Billion, Wall St. J., Oct. 12, 2010, at C1. 43. Gretchen Morgenson, Attorney General of N.Y. Is Said to Face Pressure on Bank Foreclosure Deal, N.Y. Times, Aug. 21, 2011, at B1; Gretchen Morgenson and Louise Story, In Financial Crisis, No Prosecutions of Top Figures, N.Y. Times, Apr. 14, 2011, at A1. 44. Financial Crisis Inquiry Commission, Financial Crisis Inquiry Report xxii (2011). 45. Jacob S. Hacker and Paul Pierson, Winner-Take-All Politics 1–4 (2010). 46. Raghuram G. Rajan and Luigi Zingales, Saving Capitalism from the Capitalists 312 (2004). 47. Jonathan Weil, Zombie Banks Have Us Right Where They Want Us, Bloomberg.com, Sept. 15, 2010, http://www.bloomberg.com/news/2010-09-16/zombie-banks-have-us-rightwhere-they-want-us-jonathan-weil.html. 48. Joseph E. Stiglitz, Obama’s Ersatz Capitalism, N.Y. Times, Mar. 31, 2009, at A31. 49. Pub. L. No. 111–203, 124 Stat. 1376 (2010). 50. Daniel Kaufmann, Financial Regulatory Reform: Less Than Meets the Eye on Financial Institutions, More Than Meets the Eye on Oil Companies?, Brookings, July 16, 2010, http://www. brookings.edu/opinions/2010/0716_financial_reform_kaufmann.aspx. 51. Pew Research Center, Wealth Gaps Rise to Record Highs Between Whites, Blacks and Hispanics 1 (2011), available at http://pewsocialtrends.org/files/2011/07/SDT-WealthReport_7-26-11_FINAL.pdf. 52. Schumpeter: The Daughter also Rises, Economist, Aug. 27, 2011, at 58.

Introduction 1. Robert E. Lucas Jr., On the Mechanics of Economic Development, 22 J. Mon. Econ. 5 (1988). 2. Joseph E. Stiglitz, Justice for Some, Project Syndicate, Nov. 4, 2010, http://www.projectsyndicate.org/commentary/stiglitz131/English. 3. Joseph E. Stiglitz, Freefall 225 (2010). 4. United Nations Development Project, Human Development Report 135 (2011). 5. World Economic Forum, Global Competitiveness Report 2010–2011 18, 23 (2010). 6. United States Census Bureau, Income, Poverty, and Health Insurance Coverage in the United States: 2010 14 (2011). 7. Stiglitz, supra note 3, at 225–26. 8. See Raghuram Rajan, Fault Lines 43 (2010). 9. The World Bank, World Development Report 2006: Equity and Development 1–2 (2005); see also Daron Acemoglu and James A. Robinson, Why Nations Fail 3–4 (2012) (arguing that poverty results from narrow elites’ rigging society in their favor to the detriment of all others and that prosperity results when elite power is broken and economic power is broadly distributed). 10. Mancur Olson, The Logic of Collective Action 165–66 (rev. ed. 1971). Olson’s theory transcends economic issues and applies generally to the political arena—even to matters of war and peace. Id. (“The taxpayers are a vast group with an obvious common interest, but in an important sense they have yet to obtain representation.” Further, “[t]here are multitudes with an interest in peace, but they have no lobby to match those of the ‘special interests’ that may on occasion have an interest in war”).

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8. Douglass C. North, Institutions, Institutional Change, and Economic Performance 3 (1990). 9. Daron Acemoglu et al., Institutions as the Fundamental Cause of Long Run Growth, in Handbook of Economic Growth 385 (P. Aghion and S. Durlof, eds. 2005). 10. Douglass C. North, Structure and Change in Economic History 20–32 (1981). 11. Daron Acemoglu, Root Causes: A Historical Approach to Assessing the Role of Institutions in Economic Development, Fin. & Dev., June 2003, at 27. 12. Daron Acemoglu and James A. Robinson, Why Nations Fail 428–62 (2012); Daron Acemoglu et al., Understanding Prosperity and Poverty: Geography, Institutions and the Reversal of Fortunes, in Understanding Poverty 19, 20–21 (A. Banerjee, ed., 2006). 13. J. Bradford Delong, Confessions of a Deregulator, Project Syndicate, June 30, 2011, http:// www.project-syndicate.org/commentary/delong115/English. 14. Joseph E. Stiglitz, Freefall 27 (2010). 15. E.g., Steven A. Ramirez, Market Fundamentalism’s New Fiasco: Globalization as Exhibit B in the Case for a New Law and Economics, 24 Mich. J. Int’l L. 831, 853 (2003). 16. Robert Solow, Technical Change and the Aggregate Production Function, 39 Rev. Econ. Stat. 312 (1957). 17. Robert Lucas, Making a Miracle, 61 Econometrica 251, 270 (1993). 18. Paul Romer, Economic Growth, in Fortune Encyclopedia of Economics 183, 188 (1993). 19. Philippe Aghion & Peter Howitt, Endogenous Growth Theory 1 (1999). 20. Edward B. Barbier, A Global Green New Deal: Rethinking the Economic Recovery 4 (2010). 21. Eban S. Goodstein, Economics and the Environment 119–21 (4th ed. 2007). 22. Joseph A. Schumpeter, The History of Economic Analysis 571 (1954). 23. Robert J. Gordon, Two Centuries of Economic Growth: Europe Chasing the American Frontier, CEPR Working Paper, Mar. 24, 2004, available at http://www.ifs.org.uk/conferences/bob_gordon.pdf. 24. Michelle Alexander, The New Jim Crow 4–7, 18, 92–94, 185, 218 (2010). 25. U.N. Dev. Program, Human Development Report 2011 (2011). 26. David N. Weil, Economic Growth 3, 9 (2009). 27. Id. at 3. 28. Benjamin M. Friedman, The Moral Consequences of Economic Growth 79–102, 147–48, 267–94 (2005). 29. Weil, supra note 26, at 2–3, 17, 158, and 174. 30. David Romer, Advanced Macroeconomics 145 (3rd ed. 2006). 31. Peter Saunders, Capitalism 14–17, 96–98 (1995). 32. Joseph A. Schumpeter, Capitalism, Socialism and Democracy 118 (3rd ed., 1950). 33. Jeffrey J. Pompe and James R. Rinehart, Environmental Conflict: The Search for Common Ground 68–70 (2002). 34. See Paul Krugman, Here Comes the Sun, Nov. 6, 2011, N.Y. Times, http://www.nytimes. com/2011/11/07/opinion/krugman-here-comes-solar-energy.html. 35. See Robert Kunzig, Carbon Capture: Scrubbing the Skies, Nat’l Geog., Aug. 2010, at 30 (reporting on new technology to extract carbon dioxide from of the atmosphere through the use of artificial trees). 36. David Warsh, Knowledge and the Wealth of Nations 370–82 (2006). 37. Weil, supra note 21, at xv–xvi. 38. Paul M. Romer, Increasing Returns and Long Run Growth, 94 J. Poli. Econ. 1002 (1986).

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63. Organisation for Economic and Cooperation Development, Economic Policy Reforms 2010: Going for Growth 181–98 (2010). See also Jason DeParle, Harder for Americans to Rise from Lower Rungs, N.Y. Times, Jan. 5, 2012, at Al. 64. Susana Iranzo and Giovanni Peri, Schooling Externalities, Technology, and Productivity: Theory and Evidence from U.S. States, 91 Rev. Econ. Stat. 420 (2009). 65. Organization for Economic and Cooperation Development, Eduation at at Glance: Highlights 21 (2011). 66. Daniel Golden, The Price of Admission 6–7 (2006). 67. Peter Sacks, Tearing Down the Gates: Confronting the Class Divide in American Education 161 (2007). 68. Atila Abdulkadiroğlu et al., Accountability and Flexibility in Public Schools: Evidence from Boston’s Charters and Pilots, 111 Q. J. Econ. 699 (2011). 69. E.g., Michael Heller, The Gridlock Economy 49–78 (2008). 70. Lawrence Lessig, Remix 294 (2008). 71. Paul Romer, When Should We Use Intellectual Property Rights?, 92 Am. Econ. Rev. 213 (2002). 72. Joan-Ramon Borrell and Mara Tolosa, Endogenous Antitrust: Cross-country Evidence on the Impact of Competition-enhancing Policies on Productivity, 15 App. Econ. Letters 827 (2008). 73. Romer, supra note 71. 74. Barry M. Leiner et al., A Brief History of the Internet, www.isoc.org/internet/history/ brief.shtml (last visited August 30, 2010). 75. Organisation for Economic Co-operation and Development, Education at a Glance: Highlights 17 (2011). 76. Id. 77. The Great Schools Revolution, Economist, Sept. 17, 2011, http://www.economist.com/ node/21529014; QS World University Rankings 2011/12, http://www.topuniversities.com/ university-rankings/world-university-rankings/2011 (last visited Apr. 15, 2012). 78. Mark Whitehouse, Economists’ Grail: A Post-Crash Model, WSJ.com, Nov. 30, 2010, http:// online.wsj.com/article/SB10001424052702303891804575576523458637864.html. 79. E.g., Paul Krugman, Scale Economies, Product Differentiation, and the Pattern of Trade, 70 Am. Econ. Rev. 950 (1980). 80. Paul Krugman, Increasing Returns and Economic Geography, 99 J. Poli. Econ. 483 (1991). 81. Haiwen Zhou, The Division of Labor and the Extent of the Market, 24 Econ. Theory 195 (2004). See also James K. Galbraith, Inequality and Instability 169, 270 (2012) (highlighting evidence that links more egalitarian income distribution with innovation). 82. Diana Weinhold and Usha Nair-Reichert, Innovation, Inequality and Intellectual Property Rights, 37 World Dev. 889 (2009); Zorina Khan and Kenneth L. Sokoloff, The Early Development of Intellectual Property Institutions in the United States, 15 J. Econ. Persp. 233 (2000). See also Mark D. Partridge, Does Income Distribution Affect U.S. State Economic Growth?, 45 J. Reg. Sci. 363 (2005) (finding that states with more robust middle classes outgrew states with higher inequality over the long run). 83. A Cost-Benefit Analysis of Government Investment in Post-Secondary Education Under the World War II GI Bill, Subcommittee on Education and Health of the Joint Economic Committee, December 14, 1988. 84. Edward P. St. John & Charles I. Masten, Return on the Federal Investment in Student Financial Aid: An Assessment for the High School Class of 1972, J. Student Fin. Aid, Fall 1990, at 4, 19.

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105. Oded Galor and Omer Moav, From Physical to Human Capital Accumulation: Inequality and the Process of Development, 71 Rev. Econ. Stat. 101 (2004). 106. Amparo Castello and Rafael Domenech, Human Capital Inequality and Economic Growth: Some New Evidence, 112 Econ. J. C187, C199 (2002). 107. Oded Galor et al., Inequality in Landownership, the Emergence of Human-Capital Promoting Institutions, and the Great Divergence, 76 Rev. Econ. Stud. 143 (2009); Alberto Choonny and Mark Gradstein, Inequality and Institutions, 8a Rev. Econ. Stat. 454 (2007); Stanley L. Engerman and Kenneth L. Sokoloff, Factor Endowments, Inequality and Paths of Development Among New World Economies, 3 Economia 41 (2002) . 108. Edward Glaeser, Jose Scheinkman, and Andrei Shleifer, The Injustice of Inequality, 50 J. Monetary Econ. 199, 2154–216 (2003). See also William Easterly, Inequality Does Cause Underdevelopment: Insights from a New Instrument, 84 J. Dev. Econ. 755 (2007) (demonstrating causal direction running from inequality to impaired growth by showing that if initial conditions demanded large plantations rather than family farms, initial high inequality led to inferior rule of law). 109. Brown v. Bd. of Educ., 347 U.S. 483 (1954); Brown v. Bd. of Educ. (Brown II), 349 U.S. 294, 301 (1955). 110. Steven A. Ramirez, Bearing the Costs of Racial Inequality: Brown and the Myth of the Equality/Efficiency Trade-Off, 44 Washburn L.J. 87, 96, 99 (2004). 111. Deitrich Vollrath, School Funding and Inequality in the United States, Jan. 6, 2010, at 21, available at http://sites.google.com/site/dietrichvollrath/Home/proptax. See also Era Dabla Norris & Mark Gradstein, The Distributional Bias of Public Education: Causes and Consequences, IMF Working Paper, Nov. 2004, at 14, available at http://papers.ssrn.com/ sol3/papers.cfm?abstract_id=879039 (finding that spending on education is biased toward the rich and that “weak governance leads to intensified rent-seeking over public education funds, increasing inequality, reducing social mobility, and slowing growth”). 112. Chad Turner et al., Education and the Income of the States of the United States 1840–2000, 12 J. Econ. Growth 101 (2007). 113. Catalina Gutierrez and Ryuchi Tanaka, Inequality and Education Decisions in Developing Countries, 7 J. Econ. Inequality 55 (2009). 114. Oded Galor et al., Inequality in Land Ownership, the Emergence of Human Capital Promoting Institutions, and the Great Divergence, 76 Rev. Econ. Stud. 143 (2009). 115. Mancur Olson, The Logic of Collective Action 1–2, 11–12, 165–66 (rev. ed. 1971). 116. Edward J. McCaffery and Linda R. Cohen, Shakedown at Gucci Gulch: The New Logic of Collective Action, 84 N.C. L. Rev. 1159, 1233 (2006). 117. Thomas Piketty and Emmanuel Saez, Income Inequality in the United States 1913–1998, 118 Q. J. Econ. 1 (2003). 118. Emmanuel Saez, Striking It Richer: The Evolution of Top Incomes in the United States, Aug. 5, 2009, available at http://elsa.berkeley.edu/~saez/saez-UStopincomes-2007.pdf; Thomas Piketty & Emmanuel Saez, The Evolution of Top Incomes: A Historical and International Perspective, 96 Am. Econ. Rev. 200, 201, 204 (2006). 119. World Economic Forum, The Global Competitiveness Report 363 (2011). 120. Simon Johnson and James Kwak, 13 Bankers 64–90, 90–100, 113, 203 (2010). 121. Steven A. Ramirez, Lessons from the Subprime Debacle: Stress Testing CEO Autonomy, 54 St. Louis U. L.J. 1 (2009). 122. Jacob S. Hacker and Paul Pierson, Winner-Take-All Politics 1–8, 12–13, 22–23, 27–28, 46, 48 (2010).

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152. Amartya Sen, Development as Freedom 18–20, 41, 70–86 (1999). 153. David N. Weil, Economic Growth 3 (2nd ed. 2009). 154. Geraldine Fabrikant, At Elite Prep Schools, College-Size Endowments, N.Y. Times, Jan. 26, 2008, at A1. 155. Raghuram Rajan, Fault Lines 25 (2010).

Chapter 2 1. John C. Bogle, Founder and Former Chief Executive, The Vanguard Group, Ethical Principles and Ethical Principals (Nov. 1, 2006), http://www.vanguard.com/bogle_site/ sp20061101.htm. 2. John C. Bogle, The Battle for the Soul of Capitalism 28 (2005). See also Carl C. Icahn, The Economy Needs Corporate Governance Reform, Wall St. J., Jan. 9, 2009, at A13 (“Lax and ineffective boards, self-serving managements, and failed short-term strategies all contributed to the entirely preventable financial meltdown”). 3. Lucian Bebchuk and Yaniv Grinstein, The Growth of U.S. Executive Pay, 21 Oxford Rev. Econ. Pol’y 283, 287 (2005). 4. See Lucian A. Bebchuk et al., The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000–2008, 27 Yale J. Reg. 257 (2010) (finding net payouts to senior executives at Bear Stearns and Lehman to be decisively positive despite losses on shareholdings); Sanjai Bhagat & Brian Bolton, Investment Bankers’ Culture of Ownership 4–5, 18–20, http:// ssrn.com/abstract=1664520 (Aug. 2010) (last visited Apr. 15, 2012) (reviewing compensation arrangements of the CEO at the fourteen largest firms involved in the financial meltdown and concluding that the compensation structures created incentives for excessive risk taking that resulted in positive payoffs for the CEOs while shareholders experienced negative returns). 5. George W. Dent Jr., Academics in Wonderland: The Team Production and Director Primacy Models of Corporate Governance, 44 Hous. L. Rev. 1213, 1240, 1245–50, 1273 (2008) (“the evidence is overwhelming that most boards are passive, dominated by CEOs who exert their power in their own interests”). 6. Steven A. Ramirez, The End of Corporate Governance Law: Optimizing Regulatory Structures for a Race to the Top, 24 Yale J. Reg. 313–20, 327 (2007). 7. Raghuram Rajan, Bankers’ Pay Is Deeply Flawed, Fin. Times, Jan. 8, 2008, at 11, http://us.ft. com/ftgateway/superpage.ft?news_id=fto010920081142101282. 8. E.g., James L. Bicksler, The Subprime Mortgage Debacle and Its Linkages to Corporate Governance, 5 Int’l J. Disclosure & Governance 295, 295 (2008). See also John Cassidy, Wall Street Pay: Where’s the Reform?, The New Yorker Online, July 23, 2010 (“Despite widespread anger on the part of the public, and a rare consensus among economists that faulty compensation structures were partly responsible for the financial crisis, the U.S. political system has failed to rise to the challenge”), http://www.newyorker.com/ online/blogs/johncassidy/2010/07/wall-street-pay.html#ixzz1sF1vDYv3. The OECD also concluded that “to an important extent” the financial crises arose from “failures and weaknesses in corporate governance,” particularly in the areas of compensation incentives and risk management. Organisation of Economic Co-operation and Development, The Corporate Governance Lessons from the Financial Crisis 2 (2009) (report drafted by Grant Kirkpatrick). 9. Paul Krugman, Banks Gone Wild, N.Y. Times, Nov. 23, 2007, at A37 (describing how the system of executive compensation encourages high-risk decision making).

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37. Charles Forelle & James Bandler, Matter of Timing: Five More Companies Show Questionable Options Pattern—Chip Industry’s KLATencor Among Firms with Grants Before StockPrice Jumps—A 20 Million-to-One Shot, Wall St. J., May 22, 2006, at A1 (quoting former SEC Chair Arthur Levitt). See also Jesse M. Fried, Option Backdating and Its Implications, 65 Wash. & Lee L. Rev. 853, 886 (2008) (“secret backdating, which was generally illegal . . . boosted and camouflaged managerial pay. Secret backdating thus provides further support for the view that managerial power has played an important role in shaping executive compensation arrangements”). 38. M. P. Narayanan et al., The Economic Impact of Backdating of Executive Stock Options, 105 Mich. L. Rev. 1597, 1601 (2007). 39. Paul Gompers et al., Corporate Governance and Equity Prices, 118 Q. J. Econ. 107, 145 (2003). 40. Lucian Bebchuk et al., What Matters in Corporate Governance?, 22 Rev. Fin. Studies 783 (2009). See also Thuu-Nga T. Vo, To Be or not to Be Both CEO and Board Chair, 76 Brooklyn L. Rev. 65, 126–27 (2010) (finding that evidence strongly supports limiting CEO power by splitting the board chair position from the CEO position and that many of the firms at the center of the financial crisis combined the two positions). 41. Charles P. Himmelberg et al., Investor Protection, Ownership and the Cost of Capital 38–39 (World Bank Policy Research, Working Paper no. 2834, 2002), available at http://ssrn. com/abstract=303969. 42. Inessa Love, Corporate Governance and Performance around the World: What We Know and What We Don’t, 26 World Bank Res. Obs. 42 (2010). 43. Raghuram G. Rajan, Fault Lines 139 (2010). 44. Steven A. Ramirez, Lessons from the Subprime Debacle: Stress Testing CEO Autonomy, 54 St. Louis U. L.J. 1 (2009). 45. Id. at 23–25. 46. Financial Crisis Inquiry Commission, Financial Crisis Inquiry Report 20 (2011). 47. David Wighton, Prince of Wisdom, Fin. Times, Nov. 4, 2007, http://www.ft.com/cms/s/0/ fce88e10-8b12-11dc-95f7-0000779fd2ac.html. 48. Ramirez, supra note 44, at 23–27. 49. FCIC, supra note 46, at 19. 50. Economic and Budget Challenges for the Short and Long Term: Hearing Before the S. Budget Comm., 111th Cong., 3 (2009) (statement of Ben Bernanke, Chairman, Board of Governors of the Federal Reserve System). 51. Ramirez, supra note 44, at 28–31. 52. FCIC, supra note 46, at 272–74. 53. See Ramirez, supra note 44, at 27–28 and 31. For example, a detailed and bipartisan Senate investigation of Washington Mutual (WaMu) found that “WaMu’s CEO received millions of dollars in pay, even when his high-risk loan strategy began unraveling, even when the bank began to falter, and even when he was asked to leave his post.” Indeed, “[i]n 2008, when he was asked to leave the bank, [the CEO] was paid $25 million, including $15 million in severance pay.” Over five years, WaMu paid its CEO about $100 million—plus multi-million-dollar retirement benefits. United States Senate, Permanent Subcommittee on Investigations, Wall Street and the Financial Crisis: Anatomy of a Financial Collapse, Majority and Minority Staff Report, Apr. 13, 2011, available at http://www.hsgac. senate.gov/download/?id=273533f4-23be-438b-a5ba-05efe2b22f71. Amazingly, these huge compensation payments occurred even after WaMu’s chief risk officer told the bank’s

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61. 62. 63. 64. 65. 66.

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75. Securities Act of 1933, ch. 38, 48 Stat. 74 (codified as amended at 15 U.S.C. §§ 77a-77aa (2000)). 76. Securities Exchange Act of 1934, ch. 404, 48 Stat. 881 (codified as amended at 15 U.S.C. §§ 78a-78mm (2000)). 77. Cynthia A. Williams, The Securities and Exchange Commission and Corporate Social Transparency, 112 Harv. L. Rev. 1197, 1221–22 (1999). 78. Louis D. Brandeis, Other People’s Money and How the Bankers Use It 92 (1914). 79. Marc I. Steinberg, Understanding Securities Laws §10.07 (5th ed. 2009); Melvin Aron Eisenberg, Corporations and Other Business Organizations 269–74 (9th ed. 2005). 80. Herman & MacLean v. Huddleston, 479 U.S. 375, 386 (1983) (citing SEC v. Capital Gains Research Bureau, 375 U.S. 180 (1963)). 81. Steven A. Ramirez, Arbitration and Reform in Private Securities Litigation: Dealing with the Meritorious as Well as the Frivolous, 40 Wm. & Mary L. Rev. 1055, 1083–84 (1999). 82. Rafael La Porta et al., What Works in Securities Laws?, 61 J. Fin. 1, 5 (2006). 83. Merritt B. Fox et al., Law, Share Price Accuracy, and Economic Performance: The New Evidence, 102 Mich. L. Rev. 331 (2003). 84. Michael Greenstone et al., Mandated Disclosure, Stock Returns, and the 1964 Securities Acts Amendments, 121 Q.J. Econ. 399, 447 (2006). 85. Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737 (1995) (codified at 15 U.S.C. §§ 77a, k(f), t, z, z-2, 78a, j-1, u-4, u-5, 771, and 18 U.S.C. § 1964(c)). 86. Brian D. Hufford, Deterring Fraud vs. Avoiding the “Strike Suit”: Reaching an Appropriate Balance, 61 Brook. L. Rev. 593, 641 (1995). 87. Ramirez, supra note 81, at 1087 n.156. 88. Douglas M. Branson, Running the Gauntlet: A Description of the Arduous and Now Often Fatal Journey for Plaintiffs in Federal Securities Laws Actions, 65 Cin. L. Rev. 3, 58 (1996). 89. 15 U.S.C.A. § 78u-4(b)(2). 90. Fed. R. Civ. P. 9(b). 91. Charles W. Murdock, Corporate Corruption and the Complicity of Congress and the Supreme Court—The Tortuous Path from Central Bank to Stoneridge Investment Partners, 6 Berkeley Bus. L.J. 131 (2009). 92. 15 U.S.C. §§ 77z-2(c)(1)(A)(i) and 78u-5(c)(1)(A)(i) (2006). 93. Ramirez, supra note 81, at 1076 (quoting Columbia University law professor John C. Coffee Jr.). 94. Pub. L. No. 105-353 (1998). 95. See 15 U.S.C. § 78bb(f)(1)(A) (2006). 96. Lisa M. Fairfax, The Future of Shareholder Democracy, 84 Ind. L.J. 1259, 1307–8 (2009). 97. Joel Seligman, A Modest Revolution in Corporate Governance, 80 Notre Dame L. Rev. 1159, 1162–68 (2005). 98. 17 C.F.R. § 14(a)(8)(i)(8) (2009). 99. Anil Shivdasani & David Yermack, CEO Involvement in the Selection of New Board Members: An Empirical Analysis, 54 J. Fin. 1829, 1852 (1999); see also Jonathon B. Cohn et al., On Enhancing Shareholder Control: A (Dodd-) Frank Assessment of Proxy Access, July 14, 2011, at 23–24, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1742506 (“Our evidence suggests that reforms allowing greater shareholder control (via increased proxy access) are associated with increases in firm value for those firms with shareholders who were more likely to take advantage of that access”).

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Marc I. Steinberg, The Evisceration of the Duty of Care, 42 Sw. L.J. 919 (1988). Steven A. Ramirez, The Chaos of Smith, 45 Washburn L.J. 343, 352 (2006). Id. at 865–70. Smith v. Van Gorkom, 488 A.2d 858, 898–99 (Del. 1985) (motion for reargument). Id. at 871–82. In re Walt Disney Company Derivative Litigation, 906 A.2d 27, 62–67 (Del. 2006). See In re Citigroup, Inc. Shareholder Derivative Litigation, 964 A.2d 106 (Del. Ch. 2009). Miriam A. Cherry and Jarrod Wong, Clawbacks: Prospective Contract Measures in an Era of Excessive Executive Compensation and Ponzi Schemes, 94 Minn. L. Rev. 368, 378 (2009). Lucian A. Bebchuk & Jesse M. Fried, Pay Without Performance: The Unfulfilled Promise of Executive Compensation 15–41 (2004). Joel Seligman, Rethinking Private Securities Litigation, 73 Cin. L. Rev. 93, 113–15 (2004). Institute for Policy Studies and United for a Fair Economy, Executive Excess 2006, August 30, 2007, at 31, http://www.faireconomy.org/files/ExecutiveExcess2006.pdf. Yuka Hayashi and Phred Dvorak, Japanese Wrestle with CEO Pay as They Go Global, Wall St. J., Nov. 28, 2008, http://online.wsj.com/article/SB122782362228562381.html. Restatement (Third) Agency §§ 8.03, 8.09, 8.08, 8.11 (2006). Charles W. Murdock, Why Not Tell The Truth? Deceptive Practices and the Economic Meltdown, 41 Loyola U. Chi. L.J. 801 (2010). E.g., Mary K. Ramirez, Criminal Affirmance: Going Beyond the Deterrence Paradigm to Examine the Social Meaning of Declining Prosecution of Elite Crime, Apr. 13, 2012, at 82, http:// papers.ssrn.com/sol3/papers.cfm?abstract_id=2039785 (“The affirmance effect appears evident in . . . the financial market crisis of 2007–2009” as notwithstanding “the generous fees and bonuses awarded for creating a financial Armageddon [and] the fraudulent loan documentation to support foreclosures” there has been a “failure to pursue criminal charges against any of the major actors or their legions of supporters in the legal, accounting, and credit rating fields, despite evidence of financial fraud”); Gretchen Morgenson, Case Said to Conclude Against Head of A.I.G. Unit, N.Y. Times, May 22, 2010, at A15. Ramirez, supra note 44, at 10–14. Joel Seligman, The Case for Minimum Federal Corporate Law Standards, 49 Md. L. Rev. 947, 971–74 (1990). But see Brian R. Cheffins, Did Corporate Governance “Fail” During the 2008 Stock Market Meltdown? The Case of the S&P 500, 65 Bus. Law 1 (2009) (arguing that firms removed from S&P 500 exhibited acceptable corporate governance practices but failing to consider impact of systemic legal frameworks and legal indulgences). See Joel Seligman, Rethinking Securities Litigation, 73 U. Cin. L. Rev. 95 (2004). Raghuram G. Rajan, Fault Lines 154–55 (2010). Steven A. Ramirez, The Professional Obligations of Securities Brokers Under Federal Law: An Antidote for Bubbles?, 70 U. Cin. L. Rev. 527 (2002). Ira M. Milstein, The Professional Board, 50 Bus. Law. 1427 (1995). A Working Group of Concerned MBA Candidates Enrolled in the Harvard Business School, Public Policy Proposal for the Corporate Governance College, Apr. 1, 2009, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1413286. Rakesh Khurana & Nitin Nohria, Management Needs to Become a Profession, Fin. Times, Oct. 20, 2008, http://www.ft.com/cms/s/0/14c053b0-9e40-11dd-bdde-000077b07658.html. See Harald Hau et al., Bank Governance and the Crisis: Did Board (In)competence Matter for Bank Performance During the Recent Crisis?, Euro. Fin. Rev., Feb./Mar. 2011, at 38, 40 (“Our

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154. 155. 156. 157. 158.

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Ramirez, supra note 44, at 40–53. Id. 130 S.Ct. 876 (2010). Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 951, 952, 953, 957, 971, 124 Stat. 1376 (2010). Lawmakers Seek Update From “Overwhelmed” Regulators, SFGate, Sept. 29, 2010, http:// www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2010/09/29/bloomberg1376-L9J2771A1I4H0155N1GM8LNI1JSSA71OJUPJK33U.DTL. Eric Lichtblau, Ex-Regulators Get Set to Lobby on New Financial Rules, July 28, 2010, N.Y. Times, at B1. Banks See Midterms as FinReg Opportunity, Sept. 10, 2010, Newsweek.com, http://www. newsweek.com/2010/09/10/banks-see-midterms-as-finreg-opportunity.html. Business Roundtable v. S.E.C., 647 F.3d 1144 (D.C. Cir. 2011).

Chapter 3 1. John Maynard Keynes, The General Theory of Employment, Interest and Money 161–62 (Great Minds ed., 1991) (1936). 2. Charles P. Kindleberger et al., Manias, Panics, and Crashes 26–39, 298 (6th ed. 2011); Hyman P. Minsky, Stabilizing an Unstable Economy 131–36 (1986) (McGraw-Hill ed. 2008). 3. David Ratner, Securities Regulation in a Nutshell § 11 (2d ed. 1982). 4. Joel Seligman, The Transformation of Wall Street 79 (1983). 5. Simon Johnson and James Kwak, 13 Bankers 6–8, 92 (2010) (quoting Senator Dick Durbin that the banks are the most powerful lobby in Washington and that they “frankly own the place”). 6. Thomas Ferguson and Robert Johnson, Too Big to Bail: The “Paulson Put,” Presidential Politics, and the Global Financial Meltdown (Part I), 38 Int’l. J. Poli. Econ. 3, 6 (2009). 7. Timothy A. Canova, Financial Market Failure as a Crisis in the Rule of Law: From Market Fundamentalism to a New Keynesian Regulatory Model, 3 Harv. J. L. & Pol’y 369, 385–86 (2009). 8. Bradley Keoun, Citigroup Names Obama’s Orszag Vice Chairman of Investment Bank, Bloomberg.com, Dec. 9, 2010, http://www.bloomberg.com/news/2010-12-01/citigroupsaid-to-discuss-hiring-former-white-house-budget-director-orszag.html. 9. Simon Johnson and James Kwak, 13 Bankers 91–92 (2010). 10. Ferguson and Johnson, supra note 6, at 17. 11. Johnson and Kwak, supra note 9, at 6 and 221. 12. Nouriel Roubini and Stephen Mihm, Crisis Economics 221–23 (2010). 13. Garn–St. Germain Depository Institutions Act of 1982, Pub. L. No. 97-320, 96 Stat. 1469 (codified as amended at 12 U.S.C. 1823(c) (1994)). 14. Depository Institutions Deregulation and Monetary Control Act of 1980, Pub. L. No. 96-221, 94 Stat. 132 (codified as amended in scattered sections of 12 U.S.C. and 15 U.S.C.). 15. Canova, supra note 7, at 376–77. 16. E.g., Secondary Mortgage Market Enhancement Act of 1984, Pub. L. No. 98-440, 98 Stat. 1689 (1984). 17. Dorit Samuel, The Subprime Mortgage Crisis: Will New Regulations Help Avoid Future Financial Debacles?, 2 Alb. Gov’t L. Rev. 217, 232–43 (2009). 18. Assistant Treasury Secretary Sheila Bair, Mortgage Reform and Predatory Lending: Addressing the Challenges, Assistant Treasury Secretary Sheila Bair Remarks to the

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40. Peterson, supra note 38, at 156–58. 41. HUD’s Housing Goals for the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) for the Years 2005–2008 and Amendments to HUD’s Regulation of Fannie Mae and Freddie Mac, 69 Fed. Reg. 63,580, 63,741 (Nov. 2, 2004). 42. Carol D. Leonnig, How HUD Mortgage Policy Fed the Crisis, Wash. Post, June 10, 2008, http://www.washingtonpost.com/wp-dyn/content/article/2008/06/09/AR2008060902626. html. 43. Charles Duhigg, Pressured to Take More Risk, Fannie Reached Tipping Point, N.Y. Times, Oct. 4, 2008, at A1. 44. Federal Housing Finance Agency, Conservator’s Report on the Enterprises’ Financial Performance Second Quarter 2011 14 (2011). 45. Peterson, supra note 38, at 168. 46. Nouriel Roubini and Stephen Mihm, Crisis Economics 63–64, 76, 81 (2010). 47. McCoy et al., supra note 23, at 514–15 and 516. 48. Watters v. Wachovia Bank, N.A., 127 S. Ct. 1559 (2007). 49. Gretchen Morgenson, Countrywide to Set Aside $8.4 Billion in Loan Aid, N.Y. Times, Oct. 5, 2008, at B1. 50. Steven A. Ramirez, Lessons from the Subprime Debacle: Stress Testing CEO Autonomy, 54 St. Louis U. L.J. 1, 24–26 (2009). 51. Kathleen C. Engle and Patricia A. McCoy, Turning a Blind Eye: Wall Street Finance of Predatory Lending, 75 Fordham L. Rev. 101, 123–32 (2007). 52. In re 2007 Novastar Financial Inc., Securities Litigation, 579 F.3d 878 (8th Cir. 2009). 53. Sharenow v. Impac Mortg. Holdings, Inc., 385 Fed.Appx. 714 (9th Cir. 2010). 54. Footbridge Ltd. v. Countrywide Home Loans, Inc., Slip Copy, 2010 WL 3790810 (S.D.N.Y. 2010). 55. In re Citigroup Inc. Securities Litigation, 753 F.Supp.2d 206, 2010 WL 4484650 (S.D.N.Y. 2010). 56. Richard Bitner, Confessions of a Subprime Lender 45 (2008). 57. Dorit Samuel, The Subprime Mortgage Crisis: Will New Regulations Help Avoid Future Financial Debacles?, 2 Alb. Gov’t L. Rev. 217, 232–43 (2009). 58. Richard Bookstaber, A Demon of Our Own Design 156, 250 (2007). 59. Procter & Gamble Co. v. Bankers Trust Co., 925 F. Supp. 1270, 1290 (S.D. Ohio 1996). 60. Leslie Wayne and Andrew Pollack, The Master of Orange County: A Merrill Lynch Broker Survives Municipal Bankruptcy, N.Y. Times, July 22, 1998, at D1. 61. Frontline: The Warning (PBS television broadcast, October 20, 2009). 62. Commodity Futures Modernization Act of 2000, Pub. L. No. 106-554, 114 Stat. 2763 app. E (2000) (codified as amended in scattered sections of 7, 11, 12, and 15 U.S.C.). 63. andré douglas pond cummings, Still “Ain’t No Glory in Pain”: How the Telecommunications Act of 1996 and other 1990s Deregulation Facilitated the Market Crash of 2002, 12 Fordham J. Corp. Fin. L. 467, 530 (2007). 64. Interview of Joseph Stiglitz by Frontline, Professor of Economics, Columbia University, The Warning (PBS, Feb. 17, 2009), http://www.pbs.org/wgbh/pages/frontline/warning/ interviews/stiglitz.html. 65. Letter from Warren E. Buffet, Chairman of the Board, Berkshire Hathaway, Inc., to Shareholders of Berkshire Hathaway Inc. 14 (Feb. 21, 2003), http://www.berkshirehathaway. com/letters/2002pdf.pdf.

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92. Steven A. Ramirez, Subprime Bailouts and the Predator State, 35 Dayton L. Rev. 81, 83, 93, 100–12 (2009). 93. Id. 94. Id. at 95–99; Simon Johnson, “Citi Weekend” Shows Too-Big-to-Fail Endures: Simon Johnson, Bloomberg Bus. Wk., http:// www.businessweek.com/news/2011-01-17/-citi-weekendshows-too-big-to-fail-endures-simon-johnson.html. 95. Joseph E. Stiglitz, Freefall 138 (2010). 96. Gary H. Stern & Ronald J. Feldman, Too Big to Fail: The Hazards of Bank Bailouts 66 (2004). 97. Financial Services Modernization Act of 1999 (also known as the Gramm-Leach-Bliley Act), Pub. L. No. 106-102, 113 Stat. 1338 (codified at 15 U.S.C. §§ 6801-6809, 6821-6827 (2006)). 98. Banking Act of 1933 (Glass-Steagall Act), Pub. L. No. 73-65, §§ 16, 20, 21, 32, 73 Stat. 184–85, 188–89, 194. 99. Stiglitz, supra note 64. 100. Joseph Karl Grant, What the Financial Services Industry Puts Together Let No Person Put Asunder: How the Gramm-Leach-Bliley Act Contributed to the 2008–2009 American Capital Markets Crisis, 73 Alb. L. Rev. 371, 385–98 (2010). 101. Id. at 400–3; Kim Chipman and Christine Harper, Parsons Blames Glass-Steagall Repeal for Crisis, Bloomberg, Apr. 19, 2012, http://www.bloomberg.com/news/2012-04-19/parsonsblames-glass-steagall-repeal-for-crisis.html (“To some extent what we saw in the 2007, 2008 crash was the result of the throwing off of Glass-Steagall”). 102. Arthur E. Wilmarth Jr., The Dark Side of Universal Banking: Financial Conglomerates and the Origins of the Subprime Financial Crisis, 41 Conn. L. Rev. 963, 1044 (2009). 103. Arthur E. Wilmarth Jr., The Transformation of the U.S. Financial Services Industry, 1975– 2000: Competition, Consolidation and Increased Risks, 2002 U. Ill. L. Rev. 215. 104. William E. Kovacic, The Modern Evolution of U.S. Competition Policy Enforcement Norms, 71 Antitrust L.J. 377, 441 (2003). 105. Robert Scheer, Robert Rubin’s Great Misfortune, Pittsburgh Post-Gazette, Mar. 23, 2000, at A21. 106. McCoy et al., supra note 23, at 503–4. 107. Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities, 69 Fed. Reg. 34,428, 34,451 (June 24, 2004). 108. McCoy et al., supra note 23, at 524–26. 109. Letter from Senator Charles Schumer to FDIC, June 27, 2007, available at http://graphics8. nytimes.com/images/2008/12/12/business/SchumerFDIC.pdf. 110. Erik F. Gerding, Code, Crash, and Open Source: The Outsourcing of Financial Regulation to Risk Models and the Global Financial Crisis, 84 Wash. L. Rev. 127, 155–58 (2009). 111. Gary B. Gorton, Slapped by the Invisible Hand 38–45 (2010). 112. Paul Krugman, The Return of Depression Economics and the Crisis of 2008 162–64 (2009). 113. Id. 114. Gorton, supra note 111, at 45–59. 115. Id. at 150–52. 116. It’s a Wonderful Life (Republic 1947). 117. Gorton, supra note, at 111 and 170–73.

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146. Jill E. Fisch, Top Cop or Regulatory Flop? The SEC at 75, 95 Va. L. Rev. 785, 786, 790–95, 803–5 (2009). 147. Schumer’s Stands, N.Y. Times, Dec. 12, 2008, http://www.nytimes.com/interactive/2008/12/12/business/20081214-schumer-table.html. 148. Fisch, supra note 146, at 806–7. 149. Francesco Guerrera, Don’t Eat Wall Street’s Big Fudge—It’s a Dog’s Breakfast, Fin. Times, Apr. 4, 2009, at 15. 150. Fisch, supra note 146, at 807–10. 151. Ferguson and Johnson, supra note 122, at 16. 152. Institute for New Economic Thinking, Larry Summers and Martin Wolf on New Economic Thinking, Bretton Woods Conference, Apr. 8, 2011, http://ineteconomics.org/ video/bretton-woods/larry-summers-and-martin-wolf-new-economic-thinking. 153. H.R. Rep. No. 73-1383, at 5 (1934). 154. Steven A. Ramirez, The Professional Obligations of Securities Brokers Under Federal Law: An Antidote for Bubbles?, 70 U. Cin. L. Rev. 527, 535, 560, 567–68 (2002). 155. Steven A. Ramirez, Fear and Social Capitalism: The Law and Macroeconomics of Investor Confidence, 42 Washburn L.J. 31, 65 (2002). 156. Engle and McCoy, supra note 33, at 1337–58. 157. Engle and McCoy, supra note 51, at 151. 158. Sarbanes-Oxley Act of 2002, § 101, Pub. L. No. 107-204, 116 Stat. 745 (codified as amended in scattered titles of U.S.C.). 159. Partnoy, supra note 74, at 7–13. 160. Id. at 2, 13–16. 161. H.R. Rep. No. 73-85, at 2 (1933) (quoting letter from President Franklin Roosevelt). 162. Steven A. Ramirez, Arbitration and Reform in Private Securities Litigation: Dealing with the Meritorious as Well as the Frivolous, 40 Wm. & Mary L. Rev. 1055, 1069–70, 1075–76, 1081–93 (1999). 163. Pub. L. No. 111-203, 124 Stat. 1376 (2010). 164. Jennifer Liberto, Lobbyists Swarm as Wall Street Bill Talks Start, CNNMoney.com, June 10, 2010, http://money.cnn.com/2010/06/10/news/economy/Wall_Street_Reform/index.htm. 165. Amanda Becker, Multitudes of Lobbyists Weigh in on Dodd-Frank Act, WashingtonPost. com, Nov. 22, 2010, http://www.washingtonpost.com/wp-dyn/content/article/2010/11/19/ AR2010111906465.html. 166. Dodd-Frank Act §§ 1411, 1413. 167. Dodd-Frank Act §§ 1011–14. 168. Dodd-Frank Act § 933. 169. Dodd-Frank Act § 121. 170. Dodd-Frank Act § 929Z. 171. Dodd-Frank Act § 939; Aline Darbellay and Frank Partnoy, Credit Rating Agencies Under the Dodd-Frank Act, Bank. & Fin. Serv. Pol’y Report, Dec. 2011, at 3. 172. Dodd-Frank Act § 619; Jesse Eisinger, Volcker Rule Gets Murky Treatment, N.Y. Times, DealBook, Apr. 18, 2012, http://dealbook.nytimes.com/2012/04/18/interpretation-ofvolcker-rule-that-muddies-the-intent-of-congress/ (“The path to gaming the Volcker Rule has always been clear: Banks will shut down anything with the word ‘proprietary’ on the door and simply move the activities down the hall”). 173. Dodd-Frank Act § 716; Roger Lowenstein, Derivatives Lobby Has U.S. Regulators on the Run, Bloomberg, Apr. 17, 2012, http://www.bloomberg.com/news/2012-04-17/

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Epilogue 1. Paul M. Romer, Economic Growth, in The Concise Encyclopedia of Economics 183 (D. Henderson, ed. 1993), available at http://www.econlib.org/library/Enc/EconomicGrowth. html. 2. Ronald Bailey, Post-Scarcity Prophet, Reason, Dec. 2001, http://reason.com/ archives/2001/12/01/post-scarcity-prophet/singlepage (interview of Paul Romer). 3. Paul Romer, Economic Growth and Investment in Children, Daedlus, Fall 1994, at 141 (1994). 4. John Maynard Keynes, Economic Possibilities for Our Grandchildren, in Essays in Persuasion 358 (1963). 5. Id. 6. Print Me a Stradivarius, The Economist, Feb. 12, 2011, at 11. 7. Lant Pritchett, The Cliff at the Border in Equity and Growth in a Globalizing World 263, 277 (Ravi Kanbur and Michael Spence, eds. 2010). 8. McKinsey & Co., The Economic Impact of the Achievement Gap in America’s Schools 5 (2009), available at http://www.mckinsey.com/app_media/images/page_images/offices/ socialsector/pdf/achievement_gap_report.pdf.

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Exogenous growth, 19–20, 23–24 Exposure. See Risk Externalization, 50 FAC. See Federal Advisory Council Family, 25–26 Fannie Mae, 78–79, 94, 161–62, 173–74 Fault Lines (Rajan), 121 FCIC. See Financial Crisis Inquiry Commission FDIC. See Federal Deposit Insurance Corporation Fear, 10 Federal Advisory Council (FAC), 165 Federal Deposit Insurance Corporation (FDIC), xii–xiii, 94, 172–73, 178 Federal Home Loan Banks, 54, 161–62 Federal Open Market Committee (FOMC), 97, 163, 164–65, 198 Federal Reserve, xii, 12–13, 96–97, 163–66 Federal Reserve Board, 6–7, 76–77, 164–66, 197–98; as lender of last resort, 92–98 Ferguson, Thomas, 75 Financial Accounting Standards Board, 98–99 Financial Crisis Inquiry Commission (FCIC), 48, 155–56; on fraud, 53–54, 78, 206 Financial Institution Reform, Recovery, and Enforcement Act (FIRREA), 60–61 Financial Services Modernization Act, 89 FIRREA. See Financial Institution Reform, Recovery, and Enforcement Act First Amendment, 85, 214 Fisch, Jill, 98–99 FOMC. See Federal Open Market Committee Foreclosure, xiii Fourteenth Amendment, 156 Fraud, 45, 193; accountability for, 5, 60–61, 69, 205–6; agency costs from, 51–56, 61–66; options-backdating, 52; predatory lending as, 77–81, 132–33; PSLRA on, 58–59, 80, 85, 101; subprime lending as, 78–81 Freddie Mac, 78–79, 94, 161–62, 173–74 Free market. See Laissez-faire policy Free movement, 114–17, 125, 210 Free-rider, 30, 65, 117–18; Olson on, 4, 35–36, 56–57 Fund for Peace, 193–94

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Labor mobility, 114–17, 125, 210 Laissez-faire policy, 129; in CFMA, 82, 86; for education, 119; globalization based on, 30, 108–9; hazards of, 14–16, 41–42; Southern Strategy and, 152–53, 185–86. See also Capitalism; Neoliberalism Last resort: consumer of, 110–11, 117–18, 132–33; lender of, 94–96 Law: antitrust, 26–27; banking regulation, 32–33; calibrated, 69; Citizens United on, 72; crises and, 13–14; investor protection, 52–53, 203–4; legal infrastructure, 30–33, 47–48, 76, 217–19; mandatory disclosure, 32, 57–58, 72–73, 203–4; power and, 157–58, 184–85, 186–87; race and, 140–43; regulatory competition, 99; regulatory failure, 74– 75; Smith on, 15, 17, 170, 195; underpinning corporations, 49–51. See also Laissez-faire policy; Regulatory capture; Regulatory competition; Rule of law; Securities law Lay, Ken, 199 Lehman Brothers, xi–xii, 48; consequences of failure of, xvii, 94, 173–74, 176–77 Lending: asset-based, 77; discriminatory, 8–9, 147–51, 153–54; lender of last resort, 92–98. See also Debt Leverage, xiii, 90–91, 159–60 Levitt, Arthur, 52, 68, 199 Liability: accountability through, 203–7; duty of care, 60–61, 62–67, 182, 201; for fraud, 101–2; limited, 49–50, 62–64; shareholder, 49–50 Liberty, 14–15 License to lie, 58–59 Life expectancy, 21–22 Limited liability, 49–50 Liquidity put, 54, 64, 91 Liquidity trap, 159–60, 167–69 Li Shuguang, 189–90 Living standards, 21–23 Loan. See Debt; Lending Lobbying: access to information on, xiv; amicus brief as, 79; for Dodd-Frank, 102–3; free-rider in, 65; Glass-Steagall and, 33; preparation for, 72–73. See also Regulatory capture Long Term Capital Management, 82, 83

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er, 49–50, 66–72 Prince, Charles, 54, 87 Private Securities Litigation Reform Act of 1995 (PSLRA), 66, 102, 199, 205; DoddFrank and, 103; fraud and, 58–59, 80, 85, 101 Privilege, xvii–xviii, 1, 10, 215–16; market efficiency and, 43; potential and, 131–58, 219; SAT and, 26 Procter & Gamble, 81–82 Professionalization, 67, 99–101, 200–202 Progress. See Innovation Project Censored, xiv Property rights, xv, 18, 38, 40; intellectual, 24, 26–27 Proxy, 59–60 PSLRA. See Private Securities Litigation Reform Act Psychology, 74–75 Public Company Accounting Oversight Board (PCAOB), 100–101 Public opinion, 38 Public Policy Proposal for the Corporate Governance College, 67–68 Qualified Legal Compliance Committee, 71 Race: affinity bias and, 60, 145–47; apartheid and, 35, 142, 147; Brown v. Board of Education on, 35, 141–42, 196, 208–9; conscience and, 126, 153; empowerment and, xviii, 8, 13, 131–58; hiring and, 134–35; innovation and, 117, 156–57; law and, 140–43; meritocracy and, 132–37, 145–47, 156; oppression and, xviii, 3, 40; politics and, 151–58; poverty and, 135, 143; predatory lending and, 8–9, 147–51, 153–54; Southern Strategy and, 151–53, 185–86; stereotype threat and, 121, 132, 143; transracialism, 126, 141. See also Inequality Rajan, Raghuram, 121 Rand, Ayn, 207 Ratings agency, 84–86, 101–3 Rationality: in corporate governance, 66; in human capital formation, 19; in rule of law, 3–4, 171–72, 183, 210 Rawls, John, 11, 44

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Travelers, 89 Treasury Department, xii, 107–8, 153–54 Troubled Asset Relief Program (TARP), 94–95, 161–62, 174–75, 177–80 Trust, xii UBS, 75 Unemployment. See Employment Unionization, 29 United Kingdom, 98 United Nations Human Development Index, 2, 21–22, 171 United States (U.S.), 106–9. See also specific topics Universal Declaration of Human Rights, 118–21, 126–27 Van Gorkom, Jerome, 63–64 Volcker, Paul, 111 Wall Street Journal, 78 War on drugs, 142, 147 Washington Consensus, 30, 105, 107 Washington Mutual, 55, 172, 180 The Wealth of Nations (Smith), 169–70 Wells Fargo, 8–9, 149 Wen Jiabao, 169 Women. See Gender Woodward, Susan, 165–66 World Bank, 122, 124, 126–28; Equity and Development, 125–26, 132; on human capital, 119–21, 138–39; on inequality, 4, 105, 137; U.S. control of, 106–8 World Development Report 2006: Equity and Development. See Equity and Development World Economic Forum, 194 World Governance Indicators, 193–94 World Trade Organization (WTO), 106–8, 122–28 World War II, 22, 169–71, 195–96, 202–3 WTO. See World Trade Organization

About the Author

Steven A. Ramirez is Professor of Law at Loyola University Chicago, where he also directs the Business and Corporate Governance Law Center. He has spent the past thirty years studying the intersection of the law and the economy. During that time he has written extensively on issues related to law and macroeconomics, race and diversity, globalization, law and monetary policy, law and fiscal policy, corporate governance law and regulation, securities law, and the rule of law.

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